October 5, 2013

What is your edge?

Among the most enlightening findings in behavioral finance is how overconfident most investors are. This would be trivial if they were playing with Monopoly money, but not when they are playing with real money and their financial independence hangs in the balance.  The one question you must ask before you make your next trade is:

What is your edge as an investor?

Your ‘edge’ is the advantage you have over other investors, who are also trying to find their own edge. Unfortunately, having an edge isn’t as easy as it sounds. Let’s explore some possible answers and pseudo-answers to this question, and then look for the places where we might find an edge.

Efficient market theory teaches that market prices are set by all market participants who have committed to their opinions with their wallets. Market prices digest all opinions about securities pro, con and in-between in real time.

Possible sources of ‘edge’

  • You run an investment bank that processes large orders for hedge funds. You see how the best and brightest are investing and even though there’s supposed to be an inviolable “Chinese Wall” you find yourself putting your own trades in ahead of theirs for good luck.
  • You live on Wall Street and have a large supercomputer in your apartment with a giant fiber-optical cable direct feeding into the trading platform the NYSE next door. You are a high-frequency trader and because of your superior location your orders get there a picosecond before the others. You exploit this edge to front run supply liquidity to everyone else.
  • You work for the FDA and learn that a new drug is about to gain approval. You have five minutes before the announcement. You step out into the hall to place a call to your broker in the Seychelles.
  • You invest in a hedge fund that pays people for inside information.

Unfortunately, the alpha generated by these methods is unethical and should banned if it is not already.

Pseudo-sources of ‘edge’

  • You have a good feel for technology and can tell which products will succeed and fail. Excellent! How did you do in 2000?
  • You are smarter and work harder than everybody else. No, there are hundreds of people on Wall Street who are smarter and work longer hours than you do. They are called “interns.” 
  • You have been watching the markets for years and are seasoned pro. So have millions of other people. What have you learned that no one else has? Be specific….
  • You are good at spotting trends. You mean, like day-traders? How much money did you make in 2007 off that big downward trend you saw coming? 
  • You work in the XYZ industry and know it like the back of your hand. You know more than industry analysts? You want do double down by investing your stock portfolio on top of your human capital?

True edge:

  • You are a market-beating stockpicker, like Warren Buffett, as verified by your independently-audited track record going back decades and testified to by your immense personal fortune. Congratulations! You probably spend your days and nights reading SEC filings.
  • You specialize in a tiny niche of the investment universe, possibly running a hedge fund. You analyze convertible bonds and can occasionally squeeze a few basis points of alpha by buying the bonds when they are cheap and then hedging out the interest rate, equity, and credit risk going forward. Or something similar.
  • You are a colossus bestriding a postage-stamp-sized empire, sufficiently proficient to earn a great living (but always looking over your shoulder in case a mechanical process can do it faster, better, cheaper).

No edge:

This is everyone else. We might as well come to the front of the tent and admit it. In our personal lives, we have an edge: our job skills, our good looks, our winsome personalities. But these don’t give us an inside track as investors.

Wall Street would like to pretend to give us an edge by handing us fancy trading software or the linen business card of a suave stockbroker who works for a storied firm. Danger! Warning! This is a negative edge, like a casino buying us a drink as we sit down at the blackjack table.

Nonetheless, there are sources of edge available to us.

Low-cost edge:

The first thing we have to get over here is the idea that we are going to beat the market. We’re not going to beat the market. This pill is impossible to swallow for many. They are condemned to trying to beat the market and it’s associated carnival side show.

Once we get over this, we can avail ourselves of the low-cost edge. Instead of trying to beat the market, we can be the market. We can use a few simple index funds to harvest the profits from global capitalism in our investment portfolios. This is the John Bogle way, and it’s a great way. “I don’t know anything but I just try to invest as cheaply as I can,” turns out to be a winning mantra. While we won’t beat the market, but we will beat the vast majority of other investors. That is some consolation.

The market anomaly/risk factor edge:

We can try to beat the market by taking the other side of the trade from investors who make classic mistakes. This approach tries to exploit well-documented market anomalies or risk factors that have persevered over time and across national boundaries.

We can buy small value stocks to take money from people who overpay for the hope of future growth from famous name growth stocks. We can buy and sell momentum stocks in a disciplined fashion to take money from those who hold on too long. We can buy boring low volatility stocks to take money from people who like the Wall Street action. We would do this using a few index-like funds that seek to passively engage each strategy.

The money management edge:

We can buy-and-hold. We can rebalance every year, even when it hurts. We can harvest tax losses. We can know ourselves well enough so that we don’t overinvest and then sell in despair when the market gets kneecapped. We can hold plenty of cash so we can sleep nights.

These simple measures are all within our direct control. In terms of contributing to our total lifetime wealth, they are bigger than the Beatles.

The swing-for-the-fences edge

Most pros can’t do this because the downside is too great. But you can.

 

Final thoughts

1. You can have an edge if you are willing to look for it.
2. You can believe you have an edge when in fact you don’t.
3. You can admit you have no edge and then make that your edge.
[Read the original article here.]

About the author 

Erik Conley

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

{"email":"Email address invalid","url":"Website address invalid","required":"Required field missing"}