Many billionaires and hedge funds extract dramatically more money out of the markets compared to most private investors, investment advisors, and money managers. What is the secret of billionaires and hedge funds?
Billionaires and hedge funds are smart money.
Billionaires and hedge funds use a number of techniques. Some of these techniques are beyond the reach of most investors. Fortunately, many techniques are simple enough that any serious investor can use them and reap the benefits. Here is a sample of ten such techniques.
Start With Macro
Always start with macro. Macro is the big picture. The big picture takes into account the economy, geopolitics, liquidity, central bank policies, technicals, money flows, and sentiment.
The following examples will get you started.
Precedence To Return Of Capital
Most investors give precedence to return on capital. In contrast, billionaires and hedge funds give precedence to the return of capital.
In plain English, when hedge funds are investing, they first think about getting their money back. Only when they are reasonably sure they can get their money back do they then think about the return on their invested capital.
Most investors get excited when they see an opportunity in a certain stock or ETF. They first think of how much money they will make. They hardly give any thought to the prospect of losing money. They almost never think of getting their money back, at least not until they have losses.
Not giving precedence to return of capital starts a whole chain of thought processes that, in the end, produces lower returns.
Smart money looks ahead. Many investors invest looking in the rearview mirror. These investors run all kinds of screens based on historical data to find investments. This is a backward looking approach. You would not drive looking mostly in the rearview mirror. Why would you invest analyzing mostly historical data?
Almost all drivers drive mostly looking through the front windshield. In investing, it is similar; look forward toward the future and invest. The reason investors do not look forward is because it is very difficult to look forward.
When investors look forward, the inherent uncertainty of the future leads to mistakes. To avoid mistakes, start with Arora’s Second Law of Investing and Trading, “Nobody knows with certainty what is going to happen next in the markets.”
Think about it. What happens next is the result of thousands of decisions made by thousands of investors. After the first set of decisions, thousands of additional investors make thousands of new decisions based on the market reaction after the first set of decisions. This process is repeated minute by minute, day by day, and month by month. With this understanding of the nature of the process, would you say that it is simply arrogant for anyone to state that they know where a particular stock is going to go or where the market is going to go with certainty? Once you gain the humility that neither you nor anyone else knows with certainty what is going to happen in the future, a new way of thinking is unleashed that leads to spectacular profits.
You now know one of the secrets of smart money is that they understand and accept that nobody knows with certainty what is going to happen next. Now, how do you invest?
The technique is to use probabilities.
You buy when probability adjusted risk reward ratio is low. You sell when probability adjusted risk reward ratio is high.
For example, you would not want to invest on the outcome of a coin toss because you know the probability adjusted risk reward ratio is 50%. You would not want to buy a stock or ETF if the probability of gain was only 50% and the risk was equal to the reward. However, you would consider buying a stock or ETF with a 50% gain probability and 50% loss probability if the potential reward was 10 times bigger than the potential loss.
Consider finding investments where not only the potential reward is bigger than the potential risk but also the probability of the reward is much higher than the risk.
Many investors invest because they received a tip on a great stock or they simply send their money to index funds, believing the stock market only goes up. There are many examples in history where the stock market does not always go up. One such example is the 15 year period from 1967 – 1982. The Dow Jones Industrial Average did not go anywhere – it was confined mostly between 700 and 1000.
Another example is Nikkei 225 in Japan, the equivalent to the Dow Jones Industrial Average, which hit 38,915. By March 10, 2009, it fell to 7,054 – a staggering 81.9% loss over a 20 year period.
Smart money follows a system that consistently makes money irrespective of market conditions.
Trade Around Positions
Often it makes sense to buy a stock or ETF and hold it for the long term. However, during the long term, it is never a straight line up. For example, there was a time when the stock of Amazon lost 95% of its value.
Smart money takes advantage of the volatility. They hold an appropriately sized quantity of a core position for the long term. Then they use the technique of trade around positions. In this technique, shorter term positions, separate and distinct from the longer term core position, are entered when the probability adjusted risk reward is favorable and exited when the probability adjusted risk reward ratio becomes less favorable.
This technique dramatically reduces risk because investors are not holding very large positions during unfavorable periods. Since investors are holding larger positions during favorable periods, returns can go up by 50% to 100%.
Who does not want to make 50% to 100% more money while taking significantly less risk?
Diversification By Timeframe
Markets are complex. Sometimes they are volatile. Smart money diversifies by timeframe. They make some investments for the very longer term while others for the medium to long term. They add short term trades.
This way they can take advantage of trends in different timeframes ranging from short term to very long term.
Research has shown that this approach is far superior to making investments in only one timeframe.
Diversification by timeframe performs better than simply holding only long term investments. Diversification by timeframe also performs better than having only short term trades.
At The Arora Report, we diversify by six different timeframes.
Diversification by Strategy
Most investors use only one strategy. They do well when the market conditions suit that strategy, but then they do poorly when market conditions change and that strategy no longer works. No single strategy works all of the time.
Smart money diversifies by strategy. They invest most of the money by strategies that are working. When a strategy stops working, they take profits in that strategy and put the funds to work with a different strategy that is working at that time.
Even when it is not perfectly executed, diversification by strategy provides superior returns over decades. The reason is even if some strategies do not work, other strategies that work make up for the ones that do not work.
Research has shown that diversification with multiple strategies is superior to using just one or two strategies.
At The Arora Report, we select from over 50 different strategies. Typically, the portfolio is diversified between five to ten strategies.
Most investors decide on a stock or ETF they want to buy, and they buy it at the price that it is trading at that day. Some investors average over a period of time.
Both of the foregoing are significantly inferior to using buy zones. Smart money uses buy zones. Stocks and ETFs go up, and they go down. Buy zones are designed to buy near the low end of the range. Typically, smart money scales in within the buy zones. Buy zones are a great way to buy at better prices.
The research has shown that using buy zones is dramatically superior to just averaging.
Position sizing is one of the most important techniques that billionaires and hedge funds use.
All positions are not the same. Some are very volatile. Some are less volatile. Some have low risks, and some have high risks. Some have mediocre rewards, and some have high rewards. Some are meant to be held for the very long term, and some are meant for medium term.
All of those considerations go into determining the correct position sizes.
Often, the maximum size that is determined takes into account the bulk criteria but still provides ample diversification in the portfolio. Then, positions are built by scaling into the buy zones.
The foregoing is only a sample of the techniques that you can use to become spectacularly successful in the market. To learn these techniques in detail and get access to more billionaire techniques, your best resource is The Arora Report Trade Management Guidelines. You have access to The Arora Report Trade Management Guidelines through the Real Time Feed.