Exploring the durability and replicability of investing edges.
1 minute read
Investing is a pari-mutuel system where the gains are divided among the participants. Unlike casino gambling, which is a zero-sum game played against the house, active investors compete against each other. Therefore, an answer to the question, ‘what’s your edge?’ is pertinent. Market inefficiencies can be categorised into four buckets: technical, informational, analytical and behavioural.
If you can keep your head when all about you are losing theirs…
The best illustration of a technical inefficiency is spin-offs. Institutional investors occasionally receive de minimis quantities of stock in a restructured company that is generally a peripheral part of their investment thesis and eject the unwanted holding. They aren’t strictly forced sellers, but they are certainly less careful. However, spin-offs are also an example of the transitory nature of technical inefficiencies; they have flipped from outperforming to underperforming the index since the first coming to the market.1
Informational edges have also been subject to decay. Accounts of successful investors operating in the twentieth-century are replete with stories of chance management meetings and the strenuous effort involved in simply getting hold of company accounts.2 If markets can never be perfectly efficient because there are costs to gathering information, it is undeniable that thanks to the internet the cost of information such as annual reports, press releases, strategy presentations, conference call transcripts and management access is now readily available.
However, information requires analysis in order to separate what is merely interesting from what is truly important. Analytical edges – asking different questions of the publicly available information and processing or weighing it differently to others – can be a source of advantage. For example, we focus more on cash than earnings; we appraise the outlook for a company over the next decade not just the next quarter; we tune down macroeconomic prognostications. Unfortunately, even these points of differentiation are ultimately transitory.
Behavioural inefficiencies are the most interesting because they are systematically exploitable and not able to be arbitraged away as they become more widely known; people are not (yet) able to alter their psychology. Few investors think about thinking nearly as much as they scrutinise their performance. Various tweaks to otherwise common fund management practise include keeping diaries of our decision-making to mitigate hindsight bias; deactivation intra-day portfolio valuations because they are trivial; fostering concentration by having fewer screens on our desks; deactivating the historic book cost of investments to mitigate anchoring; and company analysis that purposefully seeks out disconfirming evidence.