Finding Your Investing Edge

Finding Your Investing Edge

I’m going to continue my poker theme. Last week, I drew a comparison between poker and your odds of success as an individual versus the best in the world. This time, we’ll discuss how fund managers compete against each other and where you might have an advantage over these fund managers.

Let’s say you had the opportunity to walk the floor at the World Series of Poker. The final table is all set, so all that’s left is the best of the best. Your job is to place a bet on one of the players. Who do you go with?

But there are two issues: (1) You don’t know anything about any of the players except that they’re the best in the world and (2) All the players are required to play with their cards face-up.

One more thing – before you place your bet, each player will pull you aside and give you their story and why you should bet on them. Of course, each one expects to win. Given these circumstances, how do you choose your “fund manager?”

Remember, they are playing with their cards face up, so there is no bluffing.  The behavioral aspects have been removed and the only information that’s not available to them is the order of the cards still in the deck.

Logically, it should come down to the literal luck of the draw because they all know the same statistics, variations of cards and can do the math based on the information in front of them?

If Player A wins, how much of this outcome would you attribute to luck vs skill?  I’d think the grand majority has to be attributed to luck; how could it not be? 

So, what does this all mean?  This is the landscape that fund managers are faced with today. 

Let’s draw some comparisons:

(1) They are all the best – fund managers today are insanely smart with expansive teams of more extremely smart people. And they’re competing against each other.

(2) They are required to play with their cards face-up – any managers investing money for the public are required to say exactly what they’re buying.

(3) Each player pulls you aside to tell you why they’re likely to win. This isn’t unlike the world of mutual fund advertising or even financial advisor advertising. Everyone supposedly has super secret information that no one else has. But why are their results the way they are? More on that in a bit.

(4) The only unknowns are the cards still in the deck. Same as the investing world. The only thing unknown is what information will come out tomorrow. For the most part, I believe virtually every other piece of information is priced into the stock today.

Those who say they know what’s coming don’t. They might say they do, but they don’t. Last I checked, fortune tellers weren’t located in the nicest parts of town.

The question to answer today is, how can you find an edge?

Investing Edges

There are typically three types of generally accepted edges in investing – two of which, I believe, have pretty much gone extinct.

(1) Informational Advantage

An informational advantage is when you have access to information others do not have. It did exist, once upon a time, because not everyone had access to the same information.  Information went to those who had the greatest connections and resources, so if you had information nobody else had, you could make better decisions faster, thereby profiting.  This could, of course, lead to outperformance. Then came the internet which pretty much squashed this one.

(2) Analytical Advantage

An analytical advantage is when you have the same information but process it differently. This was entirely possible when knowledge and skillsets were unevenly distributed. Nowadays, there are at least 154,000 CFA charterholders with more than 227,000 registering to take the exams as of last summer. Due to the flood of quality candidates, teams have ballooned in size which has all but caused this edge to go the way of the dinosaur. Not surprisingly though, virtually every fund company continues to claim superiority in this regard. There are few that can back it up.

(3) Time Horizon/Patience Advantage

The last and final edge is the time horizon/patience edge.  Most of those “poker players” (fund managers) have to report their performance on an on-going basis and must answer to shareholders at every turn.  On the surface, this might seem like a good thing for accountability purposes.  But what it seems to do instead is remove the all-important time horizon/patience edge.

Any good ideas that happen to squeak through from the first two edges often require time to play out. But, when a single bad quarter can result in fund outflows (investors to leave), it has the net effect of reducing their assets under management. And as a trickle-down impact, their incomes go with it.  So, instead they tend to play closer to the vest. 

Long story short, it’s become almost impossible for active fund managers to consistently generate any outperformance of note – at least as a group. The SPIVA study is all the proof I need: SPIVA® U.S. Scorecard.

Source: SPIVA®

Note: This is just the large-cap domestic data, but all other areas look just as bad for the most part. Check out the study for more on this.

YOU Can Have An Edge Though

Here’s where it gets good. As an everyday investor, we can more or less conclude that there are few, if any, informational and analytical advantages that exist. 

Amazingly though, time horizon, patience, and discipline are advantages that never get arbitraged away.  How could it? 

If you own a low-cost, globally-diversified portfolio and are willing to hold it for long periods of time because you’ve taken the step to allocate it properly to ensure that you won’t blow it up at inopportune times, then you’re probably more than halfway home to establishing a successful retirement portfolio.

And if patience is the only real investing edge that still exists, then it would make sense that I would advocate for a passive investing strategy. This has the net effect of minimizing the overall effects and costs associated with fund managers out there chasing the first two edges that are, more or less, a mirage.  It’s my way of controlling what I can control. It’s not sexy, but it works. 

By embracing indexing, you are embracing the long-term global trends as opposed to believing you have some sort of contribution to the outcome.

Investing in stocks is about understanding short-term uncertainty in search of long-term historical certainty that the future will reward your patience. Short-term market uncertainty is not risk.  The real risk is searching for outperformance when the proper focus is increasing the probability of achieving your retirement goals via the proper asset allocation. You get there by controlling what you can control.

Thanks for reading!
Ashby Daniels

I am a Pittsburgh Financial Advisor that specializes in working with people transitioning into retirement. If you’d like more information, see Who We Serve. Or to contact me, go here.

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