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Beating Big Banks: The Case For Active Investing

By: Martin Tillier
Posted: 1/21/2013 10:23:00 AM
Referenced Stocks: BAC;GS;JPM

As I started to look through last week's earnings from the banking and finance sector, I was reminded of something. When I started in the London Foreign Exchange market there was something that, at first, puzzled me. There were hundreds of bank dealing rooms in London, and they seemingly all were profitable. How could that be? I mean, if money was being made, somebody had to lose, right? It was best explained to me by an ex-colleague who had gone to work on the sales desk of a large European bank. "We just pass around the customers'; money, and all take a cut" was how he described it.

It often seems that the stock market works the same way. Last year saw talk of Goldman Sachs (GS) traders referring to customers as "muppets," which came as no surprise to me, and, as far as I can see, healthy trading profits for all major banks from equity trading operations. If they are all making money, could it be yours? Let's be clear, I have nothing against profits. I have made my living from markets most of my life. I just would rather not donate my own hard-earned to increase the bottom line of Bank of America (BAC), JP Morgan (JPM) or Goldman Sachs.

The situation is not as bad now as it once was. Separation between research and trading desks means that buy recommendations issued to the public are based on solid research, and are not influenced by a trading desk's position. Individual brokers at the major firms usually, in my experience, really do have their customers' interests at heart. But the cold hard facts still exist. There are hundreds of bank trading rooms on Wall Street and they all still, as a general rule, make a profit. That money has to come from somewhere.

Some of this profit is undoubtedly due to a rising market. Some is due to things outside your control. Wall Street traders have better information flow and much faster execution than those on Main Street, for example. Some of it, though, comes from their customers. The uninformed public are still the buyers of last resort for bad positions.

The wealth management divisions of these same firms are also very profitable. You would expect that, with the advent of cheap online brokerages, conventional full service brokers would be struggling, but that isn't the case. There was a time when these firms encouraged active trading in individual stocks by their clients. Of course, that was when they could charge large commissions. Call me a cynic, but I am a little suspicious that the message has changed to active management (mutual funds) and buy and hold now that their competitors offer $5-$7 trades and their clients have access to real time information. Being a little more active in your account and attempting to juice returns by some trading looks appealing in that context.

If you are to do that, however, you have to think more like a trader and avoid some common mistakes.

Trading isn't easy and those doing it from home are always at a disadvantage. History shows that they have not done well, but times have changed. Commissions are much less of a barrier and real time alerts are no longer only available to your broker. One thing is for sure, though. Those trading desks aren't making all of that money from the tiny portion of their clients who have an active investing style. If Wall Street is getting profitable off you, isn't it time to try another way?

Martin Tillier has been dragged, kicking and screaming, into the 21st century and can now be followed on Twitter @MartinTillier.