The first question my ex-boss would invariably ask any aspiring macro investor was: “What’s your edge?” He could certainly have asked the question in a nicer manner since his tone tended to unnerve most aspirants. But it truly sums up the game. If you’re going to actively make investment decisions, you better have some skill that sets you apart — an edge — and you better understand exactly what that edge is.
Your edge could take many different forms, such as superior information flow, extensive industry knowledge and connections, superior quantitative skills, or access to powerful computing resources that allow data to be processed and analyzed faster and more efficiently.
Sadly, this is exactly the type of edge that most professional investors have and most retail (individual) investors don’t. For decades now, some of the brightest minds in the world have (sadly) been going into finance, attracted by the compensation potential. These formidable minds (and their algorithms) have been competing against each other and making markets more ruthless in the process. Indeed, the game gets tougher every year. There’s not much low-hanging fruit left — it’s mostly been picked over by the pros.
Now, for the good news. Unlike professional sports where most people have a precisely zero chance of ever beating a pro, every individual investor has some inherent advantages over a professional investor, and it is possible to beat the pros. Understanding these advantages and tailoring an investment strategy and process around them will increase the odds of developing an edge and beating the pros at their own game.
I lump the advantages of retail / individual investors under two broad categories:
Time Horizon: Unlike professional investors who obsess over daily, monthly, quarterly and annual performance, retail investors have the luxury of taking the long view and not having a knee jerk reaction to market noise. They can identify great opportunities caused by investors overreacting to short-term events or news that have little impact on the long-term value. As the father of value investing, Benjamin Graham, put it: "In the short-run, the market is a voting machine. In the long-run, it's a weighing machine." The shorter your investment time horizon, the more likely it is that you are speculating, not investing. And if you treat the stock market like a casino, you’re likely to suffer the same fate as the millions who donate their capital to casinos in Vegas and Macau year-in and year-out.
Flexibility: Retail investors have few of the constraints that the pros have to deal with, such as:
Benchmarks: Benchmarks are the bogeyman of almost every professional. since they have proven to be very difficult to beat over time, partly because of their lower costs. Professionals are wary of straying too far from their benchmarks lest their returns suffer in comparison. This also messes up their incentives since losing money is acceptable as long as the benchmark is down as well. Conversely, they are also incentivized to chase hot stocks and bubbles in order to keep up with their benchmarks. This follow-the-herd mentality can hurt long-term returns for clients.
Group-think: Most investors go to the same conferences, talk to the same analysts and build the same types of models. Out of the box thinking is quite difficult in most funds.
Position Limits: Many funds have strict limits on position sizes and exposures for risk management or regulatory reasons. In many cases, these position sizes are based on the volatility of the underlying security (so called VaR limits). So, when volatility is low, funds can increase their positions, but when volatility rises, these fund have to sell their positions. This tends to amplify stock market moves. For example, when stocks start selling off (for any reason), this selling will typically be accompanied by a sharp rise in volatility, which will force some funds to reduce their position by further selling. Thus, selling begets selling.
Style Boxes: Fund research company, Morningstar, introduced style boxes in 1992 to visually represent the investment positioning of mutual funds and make it easier to compare fund managers. However, these style boxes have become jail cells for some fund managers who are forced to invest in stocks that fall within their style box. Otherwise, they’re guilty of straying from their investment mandate, the dreaded “style drift,” which could lead to their being fired by investment consultants.
Sectors: Some Funds are prohibited from investing in certain industries, such as tobacco or alcohol. ESG (Environmental, Social, and Governance) investing has become extremely popular in recent years.
Size: Pros generally manage larger accounts and they have to buy in larger sizes than retail investors. This usually limits the types of investments they can get involved in since they may be too large to buy meaningful stakes in smaller companies.
Liquidity and flows: Pros always have to worry about liquidity since they are highly sensitive to outflows (redemptions) from the fund. You can’t afford to be stuck in an illiquid position when a large redemption comes through and you have to raise cash quickly. Conversely, when new money comes in, pros have to invest it almost immediately even if market valuations are extremely stretched because clients hate it when you charge a management fee but keep a significant portion of the fund in cash waiting for buying opportunities.
Headline Risk: Most pros stay away from hairy situations because when a risky security blows up, they know they’ll hauled up before their investment committees to explain their decision-making. Then they’ll have to deal with endless client inquiries about why they got into that position in the first place. A blowup will potentially hurt their reputation, and also their bonus and career path. It’s always safer to invest in less risky, widely held names. As they used to say in the old days, no one ever got fired for buying IBM stock.
Once an active investor understands these advantages, they can tailor their investment process to maximize these advantages and turn them into an edge. Here are some examples:
Think long-term. Market timing is very difficult and short-term trading that lacks a disciplined process, regard for valuation, or a discernible edge is akin to gambling: the casino always wins in the long-term. Other advantages of having a long-term perspective and trading less frequently include lower trading costs (trading commissions, bid-ask spreads) and lower capital gains taxes.
Think quality. Buying quality companies at sensible prices goes hand in hand with long-term investing. Low quality companies individually don’t generally make for profitable long-term buy-and-hold investments. They are built to be rented, not owned. As famed value investor Philip Fisher put it: “… finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear.”
Consider a concentrated portfolio. If you are an active investor, consider running a concentrated portfolios of high quality companies bought below an estimate of their intrinsic value. As successful hedge fund manager Bill Ackman puts it: "We rely on concentrated research to identify great businesses that are trading at highly discounted valuations because investors have over-reacted to negative macro or company specific events. That's the time-arbitrage part of the strategy, taking advantage when the market reacts to short-term factors that have little impact on long-term intrinsic values." This strategy is better suited for investors who have a high level of investing acumen and a good amount of experience.
Consider less followed stocks: You’re likely to face less competition in stocks that are too small (microcaps) or illiquid for professional investors. Note that this strategy is also better suited for investors who have developed a high level of investing acumen and a good amount of experience.
Develop your circle of competence: Focus on one or two industries/areas that you have interest in and really understand them. Understand the players, the suppliers, the customers etc. Read financial statements closely. Focus on becoming a “specialist.”
Now, having said all that, I’ll note that you don’t have to try to beat the pros or “the market.” Understanding that you don’t have an edge is an edge in itself since it’ll keep you away from seriously damaging your financial well being. Handing off to a competent professional or just targeting market returns via a well-diversified portfolio of index funds in many cases will be perfectly compatible with your return objectives. Sadly, few investors appreciate this. Most actually end up doing much more poorly than the market because they tend to buy and sell at the wrong times, and they invest in a haphazard manner. I’ll address this in greater detail in a forthcoming piece.
Mack Row