A question of scale (part four)
I have finally completed my quartet of posts called ‘question of scale’.
Parts one, two and three have been looking at the question of scale in the exchange markets. Four looks at what this effectively means for me and it starts with a simple question.
OK, I’m going to give you £500,000 to invest. Where will you invest it and what return will you get?
Let’s put that in a savings account. Hmm, only 1-2% interest means we will ‘only’ earn £10k a year on that, but we will be assured of that gain. You WILL get income on your investment, but that’s about all. With inflation though you may see the true value of your investment decline. The world economy is currently being bailed out by savers by the way, but that’s another story!
If I invest it in the stock market I could get a decent gain. I would expect you would earn somewhere nudging 8-10% over the next 20 years investing in a cautious manner. So you could get an average of £50k a year. The great thing with the stock market is it is very scalable so you could easily re-invest the proceeds in year two and get a 10% return on £550k and compounded upwards. Only when you run into hundreds of millions or billions does scale become an issue.
Onto betting exchanges. With £10,000 I could do a lot. There are over 10,000 events at year that could participate on so even if your return was a paltry 50p per event on average you would see yourself up 50% in a year. That’s a great result in the current environment. Is that realistic could you actually return 50% a year? When have a look a this weekend. Here are some football matches I traded before the off using £2 stakes. You can see the are a few losses in there but quite a few profits and overall and we are up £4.25 over all, a return of 212% on our stake, if not our bank. While the return is small in dollar terms the high return percentages allow you to compound very quickly.
The simple fact is, that trading with small stakes can actually produce some decent returns on a percentage basis, trading is much easier with small stakes. But increase your stakes and you start to run into some problems, basically at some point you ‘become’ the market.
If you tried to deploy all your £500k you immediately run into issues. £500k is the average amount traded on a horse race so you would have to be 100% of the market and that total includes matching on both sides. Being such a large part of the market means you would end up heavily influencing prices. In layman’s terms, you would shaft yourself because you would have to take uncompetitive pricing to get your orders filled. So you have to discard most of that money and only use what you can. If you don’t, this leads to much lower returns on capital and therefore you are better off putting that to use elsewhere. If you managed to earn 10% per month on your bank, you would more than double it every year. But you probably don’t need double the bank next year and therefore your return on capital drops by half. At some point your return will fall below it’s utility elsewhere. Basically, unless the markets experience compound growth, you can’t.
So you can immediately see that having large amounts of money in betting markets is actually a major hindrance, not a help. Therefore I tend to spend my time working out what my maximum ‘safe’ stake is and I work in and around the fringes of the market. On small stakes returns can be massive, on large stakes, not so great! IMHO it’s actually a lot easier to trade if you have small stakes. You can trade most markets at most times and you can’t influence the outcome. I have to wait till the market is just right before I can participate. So, I’m left with this situation where my activity has thrown off more cash than I can reliably put back into the market. Therefore I invest anything I don’t need.
The great thing about investing is you get a dividend, income from the underlying instrument and, hopefully, capital growth. You can also compounded growth and that can add up to a lot over the years and it eventually creates a massive divergence to something you can’t compound. Over 13 periods you end up with double the return of a static investment. But to invest you need capital and that’s where the betting exchanges came into play for me. But hopefully you can also see why I am not tempted to start my own fund, I have enough trouble putting through my own money. Even if I could the markets are not experiencing compound growth so that’s self limiting for me.
So, years ago I gambled before moving onto investment. Then through investing I discovered betting exchanges; investment gave me the capital to gamble, now it appears I have gone full circle and gambling has given me capital to invest! Who knows where we will be in another decade? I’ll still be plugging away doing both I suspect.
Category: Trading strategies
