Investing Edge
It’s often said that if you don’t have an edge you shouldn’t invest – this is especially true if you believe the market to be more efficient than not.
Personally I think that most of the market is mostly efficient most of the time. A corollary of this is that parts of the market are less efficient some of the time – especially small caps during dislocations and in valuing longer duration quality (due to impatience / incentives).
Buffett’s Circle Of Competence concept is probably the starting point here, when he says "Know your circle of competence, and stick within it. The size of that circle is not very important; knowing its boundaries, however, is vital." His simpler maxim on this is “Risk comes from not knowing what you're doing.”
I see the importance of having an edge over the market as being an extension of this.
Without an edge, the market will usually exploit its relative edge and the longer you play, the more you will lose. This is perhaps best summed up by the adage “If you’re playing poker and after the first few hands you can’t work out who the patsy is, it’s probably you”.
There’s usually 3 or 4 sources of potential edge, that gets discussed. I tend to favour Michael Mauboussin’s BAIT framework. See p255 here for his full paper https://mjbaldbard.wordpress.com/wp-content/uploads/2020/09/michael-mauboussin-e28093-research-articles-and-interviews-2017-2020-1.pdf
B = Behavioural is probably the most achievable source of genuine edge for individual investors (in theory at least). Think Buffett’s quote “Be fearful when others are greedy and greedy when others are fearful”. Easy to say, hard to do. You will probably need a solid process to keep you on track, otherwise your emotions can steer you in the direction of the herd. For some inspiration on this, I recommend Daniel Crosby's book The Behavioral Investor - https://www.goodreads.com/book/show/36960014-the-behavioral-investor.
A = Analytical is hard to compete with the street when it’s made up of smart, competitive, well resourced analysts who love doing this all day every day. AI might make this even harder to compete with better resourced operators (with inhouse AI capabilities) for a while, but the playing field will hopefully level out as AI becomes more mainstream. I often think of the quote: “AI Won't Take Your Job, but Someone Who Can Use It Might”.
I = Informational was a big source of edge in the bad old days but now insider trading laws and the internet have largely made the market more efficient so (in theory at least) everyone has access to the same information at the same time. Finding less publicly available qualitative information may still be a potential source of edge but you never know what the market also knows at this level.
T = Technical is largely about being able to go where others can’t. High Frequency Trading might be a source of this. Buying illiquid small caps that larger funds can’t is another. Having a longer holding period when not constrained by quarterly / annual fund reporting requirements and performance fee incentives is a potential source too.
How to think about these.
It’s notoriously hard to gain, much less sustain an edge in investing but that doesn’t mean you shouldn’t try.
One way to think about edge is table stakes. Having a decent baseline capability in each of these is probably required to play the game for any period of time, let alone play it well.
I tend to think that Analytical and Informational are the 2 biggest sources where you can lose and Behavioural and Technical are the 2 biggest sources of potential edge.
So I try to have a clear process to ensure I have good information sources and analysis of these, remembering that I am competing with a lot better resourced investors that I. This is especially true at the financial statement level where you are competing with algorithms – I will never keep up with them but I try not to fall too far behind. My process is always improving but the focus is on completeness, speed and ease of use. Example, I use a data provider to extract and standardise granular Financial data which I then distil into the most useful information based on my strategy. I can run this from start to finish in just over an hour to give me full and half year financials, ratios, growth, margin and price multiple histories, reverse DCF, mgmt. skin, multiple of holding over salary, insider buying and selling, etc, etc.
I don’t consider this a source of edge but really just trying to keep up with the market. Then I am free to try to build on this foundation.
Combinations of Edge
To assess your overall edge, you could give yourself a %age score vs the market and multiply these together. That way a particularly low score in one will hit your overall estimate hard. If for example you weren’t using the internet, your Informational Edge would probably be no higher than 20% and this would be a big problem for you and your score no matter how high your Behavioural or Technical Edges were.
This also allows you to manage the downside by minimising your loss on Analytical and Technical to say 80% or the market’s capability while trying to maximise your Behavioural (patient, disciplined) and Technical (Small / Mid caps, longer holding period) so they are > 100% of the markets estimated capability.
If for example you estimate your analytical and informational edges to be 80% each and both your Behavioural and Technical edges to be 125% each, multiplying these together would get you to 100%, so you’re all square. If you think these estimates are reliable and you believe you can (and will) improve these scores, you may have an edge to exploit, if not, index funds might be a better path.
That’s how I think about it anyway, keen to hear any different perspectives / stinging rebuttals.