Flash Boys & the Case for Investing Locally

May 2014

In the Calgary airport I picked up a copy of Michael Lewis’s new book ‘Flash Boys’.  Lewis is the author of ‘Money Ball’ and ‘The Blind Side’ specialising in unusual storytelling that is ripe for conversion to film.  Lewis has a way of weaving together characters and complex issues into a story in a way that, even if you’re not interested in finance, is super engaging.  But if you’re an economic geek and appreciate a good inflation joke, his books are the equivalent to the Twilight series to a crowd of 14 year old girls.

‘Flash Boys’ takes readers through the discovery by a group of Wall Street guys that the US stock markets have been rigged to take small profits from all investors by high frequency traders, big Wall Street banks and even the stock markets themselves. The scale and sophistication of the of the operation is almost beyond comprehension with high frequency traders essentially stealing an estimated $20 billion a year from investors - and not just regular investors; mutual fund managers that have full time people literally managing trillions of dollars in assets couldn’t stop this theft.

About three chapters into the book I had a deja vu moment, or deja vu thought to be exact.  I had the same thought I had previously had while reading Michael Lewis’s 2010 book ‘The Big Short’ - the in depth look at on the subprime debt crisis where pension funds and insurance company investors got screwed as well.

The thought:  “How can people ‘invest’ in what they clearly don’t understand?”  Like the famous poker quote; “If, after the first twenty minutes, you don’t know who the sucker at the table is, it’s you”

About once a month I have a discussion with one of my good friends about stock market vs. real estate investing.  Honestly, I am not sure if he is just winding me up or if he actually believes that barely researched stock picking a good investment strategy.

Anyway, he recently wanted to put invest a large chunk of money into Apple a few days before the company made a major announcement.  The announcement was predicted by experts in the financial media to increase the value of the stock.  His information came from a free podcast available to anyone on the internet.  He doesn’t work as a stock analyst nor does he know anyone who covers technology stocks as their full time job.  He doesn’t work for Apple or have a close friend or relative that works for Apple (although that may be considered insider trading if he did).  So where’s the advantage?  How could he possibly know more?

Ironically, he’s one of the people that recommended that I buy ‘Flash Boys’, a book all about the informational disadvantage that investors face.  The one quote in ‘Flash Boys’ that really drove the point home was a side note midway through the book:

In early 2013, one of the largest high-frequency traders, Virtu Financial, publicly boasted that in five and a half years of trading it had experience just one day when it hadn’t made money, and that the loss was caused by “human error”.  In 2008, Dave Cummings, the CEO of a high-frequency trading firm called Tradebot, told university students that his firm had gone four years without a single day of trading losses.  This sort of performance is possible only if you have a huge informational advantage. (page 109)

This information gap is the real difference between investing in the stock market (or bond market for that matter) and controlling your own investments in something like local real estate.  

Which is easier or more likely to be profitable?

  1. Understand equity markets to the same degree as the 32,000 Goldman Sachs employees as well as keeping up with changing regulations that require a specialized law degree to follow while competing with the likes of Warren Buffett and trying not to be ripped off by high frequency traders who are willing to pay $14 million for a three millisecond trading advantage; or

  2. Understand the local real estate market to the same degree as a local realtor (they’ll return your call) as well as keeping up with local regulations from our fairly transparent city council.

The comparison isn’t just accurate for real estate, but really any local expert.  Look around town and you see many successful local businesses that at some point was probably looking for a financial partner. To make great returns you don’t need to get inside (and likely illegal) information from senior management of a publically traded company; you probably already know the CEO or future CEO of several local companies who will happily give you timely and accurate information on their business.

Understandably, not everyone wants to put in the effort to understand their local market.  In these cases, I usually suggest Index Funds.  

But if you do want to put a few hours into understanding an investment, to me the choice is clear: work hard to understand what’s going on in your local market.  

Since CloudWorks didn’t pay the $14 million for 3 millisecond trading advantage between Chicago & New York and Warren Buffett didn’t ask us to go halfsies on GEICO, we lean towards local investing. In the case of property this means we (aka Rob) scours town for opportunities. Once we find something that looks promising, we put most of our time into due diligence; way more due diligence than is possible for a publically traded company without being an insider. The result: higher returns with lower risk.

How did the investment in Apple end for my friend?  The announcement was made, the stock dropped, but luckily he had decided to invest in the local market and is on track to make a decent return.