Most of the country’s 50 million retail investors are at a disadvantage to institutional investors.
THE BIG BOYS
These much larger, better equipped investors – hedge funds, pension funds, proprietary trading firms, and the like – use complex quantitative systems that rely on statistical analysis of the millions of data points that affect stock prices. Combined with fundamental analysis, informed by deep research teams and access to pricey subscription-based research, these real-time predictive systems help institutional traders make well-informed trading decisions.
On the surface, retail traders do the same thing. They look at revenue growth, price-to-earnings multiples, and a cursory review of technical factors, such as candlestick patterns. However, when push comes to shove, the average retail investor typically trades based on intuition, relying on familiar set-ups based on the books they have read or trading classes they have taken.
IT’S ABOUT TIME
Why stop there? Time limitations. The average investor – the dentist, the teacher, the accountant – does not have time to track fundamental and technical indicators of more than three or five stocks at a time. As such, retail traders miss familiar patterns because research requires a lot of time.
FOUR MAIN STEPS
Thankfully, retail traders can adopt some practices level the playing field. To do so requires four main steps – though each step has mini parts to them as well:
1. Determine the universe of stocks to consistently analyze.
2. Conduct fundamental analysis to determine whether stocks are undervalued or overvalued.
3. Leverage technical indicators to determine ideal entry and exit points.
4. Monitor and rebalance to make sure that the portfolio is positioned for changing market dynamics.
Cutting down the universe of stocks to a manageable group – whether by industry, market capitalization or some other factor – will help investors perform the fundamental evaluation that is always necessary. For example, use discounted cash flow (DCF) analysis and net asset valuation (NAV) methodology. DCF analysis places a value on the company based on the cash it can potentially generate in the future – at a discounted rate. NAV is the value of assets minus liabilities.
FUNDAMENTALS AND TECHNICALS
Fundamental analysis is critical, but without knowing optimal entry and exit points, it falls short. This is where investors should become familiar with technical analysis. However, even with the explosion of tools available via online brokers and the web, this is absolutely the most challenging step for retail traders.
To be effective with technical analysis, it is often helpful for investors to limit their use of technical indicators to those that are both understood and regarded by most traders as effective. Regardless of which and how many indicators are used, traders need to leverage them all consistently, and to remove hunches and intuition from the process. This is how institutional trading firms create trading systems. It is only with systems that traders can learn if the success of their trading is based on anything more than random luck.
Fundamental and technical analysis are critical, but are not enough to make a successful trading system. Indeed, the work has just begun once the trade is made.
Each day presents investors with a new environment, one that requires reevaluation of the markets, specific stocks and trading indicators. Market inputs are constantly changing and it is the ability to act on these inputs and to constantly optimize their portfolio to different macro and micro risk parameters. Likewise, retail traders should constantly adjust their outlook on specific stocks.
One example where this is important: many retail traders think that if a stock they like falls in price, it is more of a “buy.” This type of thinking doesn’t have any role in institutional programs – and it doesn’t have any role in a retail portfolio either.
The final step in trading more like institutional traders is to monitor market sentiment and manage the portfolio for correct position sizes and portfolio exposure to different risk attributes.
BALANCE YOUR PORTFOLIO
A good rule of thumb is to try to balance the portfolio with positions that are short in stocks that have been underperforming the market and long in stocks that have been outperforming – all based on the fundamental analysis.
Doing these things will help retail traders trade more like institutional traders – though to really be on the same level would require a complex statistical system of your own.
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Related Reading:
Trading With Institutional Money Moves
Understanding Institutional Order Flow and Supply and Demand Trading Strategy
