The Informational Advantage - What do you Know that Other People Don’t

Bank of Japan Deputy Governor Kiyohiko Nishimura discusses "informational advantage" this week at the Lujiazui Forum on economics and finance in Shanghai:

"In my understanding, the Volcker Rule [proposed legislation restricting banks from making certain speculative investments] is designed to deter banks from taking excessive risk in capital markets, where volatility is inherently high and in which bankers do not necessarily have informational advantage in predicting market developments.

Rather, the Volcker Rule urges banks to return to their traditional stronghold of commercial banking business, in which they can utilize their informational advantage based on long-term relationships with their customers."

Informational advantage is a key investment concept. What do you know that other people don't?

If everyone knew everything, investment wouldn't exist. The market would price all investments (stocks, bonds, commodities) perfectly. There would be no room to buy something under-priced and then sell it at a profit after it goes up.

But (fortunately or not) we live in an imperfect world. Some people know more than others. Investment opportunities arise when people who know less dominate a market. The lack of knowledge causes an under-pricing, which more knowledgeable buyers spot. Eventually the wider market sees the unrecognized value and the price rises, making money for the early buyers.

(Investment opportunities also arise when people with good knowledge fail to act rationally on what they know. This happens during panics and manias. Buyers and sellers know better, but their emotions drive them to set the wrong price.)

The key is recognizing where you hold the informational advantage.

As Deputy Governor Nishimura points out, banks' "fountain of knowledge" is the relationships they hold with their customers. Banks (by definition) hold detailed financial records about the people they deal with. Studying this, it's possible for a bank to make better judgments than an outsider about who is likely to pay back a loan and who is likely to go deadbeat.

This means banks have a leg up on everyone else in the loans business. Do they have a similar "insider view" of the stock market, where many of them have been increasingly investing over the last several years?

Maybe in specialized cases, but there's nothing inherent to the operations of most banks that would give them more information about stocks. They know just as much (or less) than investment funds, brokers and even individual investors.

The informational advantage can be especially strong in natural resources. Renewables, mining and petroleum are sectors understood by a relatively small number of professionals. Creating potential for mis-pricings of resource assets and stocks.

Teck has a huge informational advantage in analyzing zinc deposits. Built up over decades of expense in analyzing every ore body they could find on the planet. DeGolyer MacNaughton has an informational advantage in U.S. shale gas. GeothermEx (and now Schlumberger) has a big advantage in assessing geothermal prospects.

There are specialty funds that retain professionals from all of these fields in order to gain informational advantage. There are investors who travel to projects worldwide 340 days of the year to gain informational advantage. There are brokers who socialize with the industry's inner circle for most of their waking lives in order to get the informational scoop.

If you're investing, what do you know that most others don't?

By. Dave Forest of Notela Resources