Would it be fair to say that most stock market participants are out looking for a miracle-pill that can grant them an instantaneous ability to beat the market? Thing is, there won’t be one. And if you’re ever offered something similar – run! But that said, there are indeed two very important words investors have to remember to give them that edge in the investing-game: time arbitrage. In the world of high-finance, arbitrage is the act of buying an asset in one market and selling it at a higher price in another. A classic case of arbitrage at work can…
Would it be fair to say that most stock market participants are out looking for a miracle-pill that can grant them an instantaneous ability to beat the market? Thing is, there won’t be one. And if you’re ever offered something similar – run!
But that said, there are indeed two very important words investors have to remember to give them that edge in the investing-game: time arbitrage.
In the world of high-finance, arbitrage is the act of buying an asset in one market and selling it at a higher price in another.
A classic case of arbitrage at work can occur during acquisitions. Sometimes, inexplicable price discrepancies can occur where a company’s shares are selling for a price lower than what it would be acquired at, giving investors an opportunity to earn a profit consisting of the spread between the acquisition price and the prevailing market price.
There can be other fancier examples of arbitrage. Let’s imagine that gold’s selling for US$1,300 per ounce in the USA and S$1,400 per ounce here. We know that the exchange rate between the US dollar and our local currency’s is around S$1.25 for every US$1.
If we bought one ounce of gold at S$1,400 in Singapore, we can then immediately sell it at US$1,300 in the American market before converting our proceeds of US$1,300 into S$1,625 at the prevailing exchange rate. In this way, our total earnings sans transaction costs, would be S$225 (S$1,625 minus S$1,400).
From these two examples, we can see that arbitrage is all about taking advantage of pricing inefficiencies for the same asset in different markets.
But, how does that relate to our magic phrase, time arbitrage? Simply put, with the concept of time arbitrage, investors are taking advantage of pricing inefficiencies that can occur between groups of market participants with different time horizons.
In Singapore, our stock market, measured by the Straits Times Index (SGX: ^STI), has grown at slightly more than 5% per annum (excluding dividends) over the past 25 years from 834 points at the start of 1988 to around 3,200 points today. That hasn’t come by accident. Rather, the gains in the stock market are a reflection of the growth of Corporate-Singapore, which in turn, has flourished along with the nation’s economy.
The 5% per annum growth that has occurred in the past is no guarantee that the index would continue growing at the same clip. But, historical long-term growth rates are often a good gauge for what it can do going forward.
So, if you believe that Singapore’s economy would continue doing well for years to come as it has done in the past, then the STI might achieve new heights in the future. But you can rest assured that along the way, the index would sink like a rock at some point in time – very possibly occurring multiple times.
Stock market participants with short-time horizons might be unable to take the losses and bail out. But not you.
You’ve faith that the chances of the stock market being higher in the future are good despite a temporary collapse, so long as our politics and economy are functioning normally. You want to hold stocks through short-term collapses – or even buy more at depressed prices – knowing that they stand a good chance of being worth more in the future. You think there’s a price inefficiency between what stocks are worth now compared to what they might be worth over the next one, two, or even three decades.
You’re an investor who wants to profit with the concept of time arbitrage.
Individual shares, like the broad market at large, can also often be inefficiently priced very cheaply now compared to what they might be worth many years into the future as their businesses grow and profits increase.
10 years ago, investors who recognised the competitive advantages that certain companies -like Jardine Strategic Holdings (SGX: J37), Dairy Farm Holdings (SGX: D01), Super Group (SGX: S10), and Raffles Medical Group (SGX: R01) – possessed, which allowed them to grow their businesses for a decade, would now be sitting on gains in excess of a 1,000%.
To borrow from Morgan Housel from The Motley Fool USA, as investors, we all have the opportunity to focus on the long term and profit from the idea of time arbitrage. The question is, Will you?
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns shares in Super Group and Raffles Medical Group.