Retail Investing and How to Compete with “Buildings Full of PhDs”



Edited by Paige Rudich

Who I am: A retail investor who is active in Reddit’s investing communities; I have a Finance degree and am working on an Applied Math PhD. I have been keeping my friends up-to-date on the ongoing GME drama, and several of them have suggested I write down my take on the matter. So welcome to my first ever internet writing, there will probably be more in the future. However, there are already several good accounts of what is happening/what happened to GME [for example], so the focus of this article is going to be a little different.

The GME short squeeze has shone a spotlight on Reddit’s investing communities, but media coverage would lead you to believe that we are all either a bunch of basement-dwelling morons with no idea what we are doing, or an aggressive and malicious force colluding to bring down Wall St. From CNBC talking heads comparing WallStreetBets members (WSBers) to terrorists [saw it live, can’t find the video] to the New York Times calling us “dumb money” that is “propelled by a mix of greed and boredom” [link], the bias is clear.

When I first dipped my toes into Reddit’s investing threads, I had the same condescending attitude that all of Wall Street holds, the sentiment that retail traders just can’t compete with the professionals. It’s an attitude taught in college and the professors give you data to back it up. However, after actually seeing and participating in Reddit’s finance subs (henceforth known as FinReddit for convenience), I realized that Wall Street is significantly underestimating the power of crowd-sourced investing. My goal is to convince you that retail (or amateur) investing has a competitive edge arising from the way information flows in the modern era.

The Efficient Market Hypothesis

If you go to school to learn about the stock market, they tell you that the market is efficient in theory, and only inefficient if you are a supercomputer. All this really means is that as far as anyone knows price movement is random. As Mark Hanna puts it in the Wolf of Wall Street: “Number one rule of Wall Street. Nobody — and I don’t care if you’re Warren Buffet or if you’re Jimmy Buffet — nobody knows if a stock is going to go up, down, sideways or in circles”.

I had a professor in college who told us that “the only way to predict stock prices is to predict the news”. The theory behind this (backed up by the data) is that people on Wall Street have all the information available when they make investment decisions. It doesn’t matter if you have a friend who works at GM who knows about some new product they are working on, Wall Street has friends there too, they knew before you and it’s priced in. How could you possibly know more than the major investors who drive the price of the company and whose JOB is knowing about the market?

The efficient market theory is defended as becoming more true over time. As more people go to Wall Street to make their fortune, there are more people studying the market, and therefore prices should be more efficient. In recent years, the number of institutional firms applying machine learning and similar techniques to trading, and using any and all data available (from the price of bananas in California, to the weather on Wall Street next Tuesday) has exploded. This prevalence of smart people writing algorithms to trade for them has led to the phrase “buildings full of PhDs”.

The going belief is that there is nothing an individual can do to compete with the institutional players because the institutions have “buildings full of PhDs”, and everything original has already been done. Computers will identify any inefficiency in pricing before the individual can see it, and the computers will take advantage of the inefficiency until it is corrected.

Frankly, this is bullshit. I don’t mean that the Efficient Market Hypothesis (as discussed in academic circles) is bullshit, I mean the attitude that Wall Street is too smart to lose to an amateur is bullshit. I would have preached that attitude 6 months ago, but I have now seen enough on FinReddit to convince me it is an outdated notion. I do not know precisely when it stopped being true, but it definitely has. So let’s look at the other side.

Not So Dumb Money

I want to be very clear that in the following paragraphs I am not endorsing YOLOing money on options without understanding what you are doing, I am defending the idea that FinReddit and FinTwitter have made it possible for an amateur to knowledgeably invest, and be profitable.

There is a lot of historic evidence to suggest that day traders lose money, basically always. This article gives several statistics about traders, but the major takeaway is that about 80% of day traders lose almost all their money. Day traders are retail traders who buy and sell an asset on the same day. It is very likely that if you start trading now with just an air of confidence and no exposure to market mechanics, Wall Street will take everything you put in. “Time in the market beats timing the market” as the saying goes. Until you know what you are doing, you should stick your money in a couple different ETFs and leave it alone.

The advice given to new traders is typically: “if almost all day traders lose money, what makes you so different?”. As an individual I would agree, you can’t beat the market at its’ own game unless you get lucky. Here’s the thing though, you aren’t just an individual anymore. FinTwit and FinReddit have created an ecosystem that allows retail investors to win by working together; not colluding to cause short squeezes like WSBers are being accused of doing (which is nonsense), but by crowdsourcing quality research.

Most of the advice and research posted on FinTwit and FinReddit is garbage and/or a scam. However, there are millions of people reading, commenting in, and posting in these forums. The media and Wall Street would have you believe that its mostly degenerate gamblers, and people living in their parent’s basements. That is a generational underestimation. An entire generation of 20–30 years olds grew up with the internet and social media, and we are all still using it. The economic crisis means a lot of us are highly educated, but aren’t using that education in the workforce. These forums do have their fair share of gamblers, but there are also tons of brilliant people contributing to the forums who are looking for an edge to make a little money in an economy that has left most of us behind. The sheer volume of people involved online means that buried in the garbage there is also a tremendous amount of gold. When you have millions of people searching these forums looking for good ideas, the gold is uncovered. Flaws in investment ideas are pointed out and discussed, and good analysis is expanded on by people from all sorts of different backgrounds.

In the old days, Wall Street really did have access to information that the individuals didn’t. Data was expensive, and no amateur could do a thorough enough analysis to compete. Now all that information is online and millions of people are working together to compile it: CEOs and other executives constantly tweet updates about products and investments, people file Freedom of Information requests to access passenger lists and predict deals between companies by cross-referencing where executives are going, and so much more. Some people try to monetize their contributions, but most of us do it open source. I am in a trading group with a couple thousand other people that work collectively to vet trades and everything we do is freely available online.

So how do you beat the “buildings full of PhDs”? You beat them with millions of people working together desperately trying to find an edge in the market, because for many, trading is the only way to make the dream of retirement before death a reality. If you want to get into trading, don’t come to our forums expecting to learn how to strike it rich all on your own. Come to our forums and stay, learn how to spot good investment ideas, and over time give back by developing some of your own ideas to put back into the open-source investing project that FinTwit and FinReddit have become.

The Proof is in the Pudding

As just one example of what individuals can accomplish by working together, I present to you NOPE. The typical pattern when someone discovers an opportunity to outperform the market is: they take advantage of it to make money -> other people find out about it over time -> so many people find out about it that the opportunity goes away because prices became efficient due to everyone trying to take advantage. A few months ago, Lily Francus (name links to her twitter), had an idea about using order flow to predict how market-makers will hedge in the immediate future. If you don’t understand what that means, it’s okay, you don’t have to (if you want you can read about it via Lily’s blog here or for an in-depth look see the white paper here). The important thing is that Lily’s model is predictive; it suggests how an extremely liquid asset should behave in the next couple hours. Several other people, myself included, joined the project to build it out. The website I linked to is a free open-source website, available to everyone, that outputs NOPE in real time. Lily’s blog and Twitter tell you how to use and understand NOPE. Others (including me) have been working on optimizing and improving the strategy for doing so. I have posted the results of my backtests of various strategies on my twitter.

The results are astounding, NOPE can predict market movements correctly about 70% of the time, and some of the strategies tested outperform the market quite handily. Don’t believe me? You don’t have to. This is an open-source git repository where you can find the data we are using to backtest NOPE, as well as the code I’ve written for doing so. If that’s not enough, Michael Burry himself, the guy from “The Big Short” who saw the housing crisis of 2008 coming years away, has retweeted Lily’s thesis. You can also go look at all the hedge fund managers and quants hitting up Lily on Twitter for help implementing their own NOPE indicator.

Funny thing about this is that everyone knows about NOPE now, so it should stop working. It hasn’t though. Lily discovered a fundamental flaw in the way the market is built. Maybe one day it will be repaired, but this is something that won’t stop working just because everyone starts using it.

This is only one example, my point is that trading by open-source committee turns out to be a good strategy. There is plenty of opportunity to make money by trading; if there wasn’t, Wall Street wouldn’t be hiring so many people to do it. Retail is going to continue working together to find these opportunities, and if you learn to identify the gold in the garbage pile, you can make some money too.

Parting Advice for People Looking to Join the Game

  1. If someone is trying to sell you a service, remember that if it really worked they wouldn’t need to sell it to you.
  2. Chart Patterns are astrology for traders, please ignore all of it. People draw shapes on stock charts and try to pretend that it predicts where the stock is going to go, but there is a mountain of evidence showing that it’s just confirmation bias.
  3. It is okay to not fully understand someone’s analysis, if you understand enough to figure out whether or not they are talking out of their ass. It is NOT okay to start trading options without understanding what the contracts mean and the quite significant risks involved. We use options because options gives us leverage, but you can lose your entire portfolio in an instant (or worse) if you aren’t doing proper risk management.
  4. Low float stocks are very easy to pump and dump. If a previously unknown stock starts trading at much higher volumes, without any news justifying the new interest, someone is probably taking advantage of social media to pump it before they offload all their shares onto people like you and crash the price down to nothing. Penny stocks are particularly susceptible to this, stay away from those entirely until you really know what you are doing.
  5. If you want to double-check financial information to make sure that someone is posting accurate numbers, you can find all company filings for free from this government website.

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