InvestingDemystifiedThe following is an excerpt from Lars Kroijer’s Investing Demystified – How to Invest Without Speculation and Sleepless Nights. Kroijer is a former hedge fund manger who recounted his experiences in the book Money Mavericks – Confessions of a Hedge Fund Manager. He asks whether the individual investor, let alone most professional investors, have an edge in the markets. In that light Kroijer explains in his book how investors can build simple, index portfolios.

Excerpted with permission of the publisher FT Press from Investing Demystified – How to Invest Without Speculation and Sleepless Nights by Lars Kroijer. Copyright (c) 2014 by Lars Kroijer.

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Edge over the markets and do you have it? by Lars Kroijer

As investors we are bombarded with stock tips about the next Apple or Google, read articles on how India or biotech investing are the next hot thing, or are told how some star investment manager’s outstanding performance is set to continue.  The implicit message is that only the uninformed few fail to heed this advice and those that do end up poorer as a result.  We wouldn’t want that to be us!

What if we started with a very different premise?  The premise that markets are actually quite efficient.  Even if some people are able to outperform the markets, most people are not among them.  In financial jargon, most people do not have edge over the financial markets; they can’t consistently outperform the market by picking different securities / sectors / geographies from the market as a whole, especially after costs.  Nor are they able to pick which of the thousands of fund managers have the ability to do it for them.  Accepting, embracing, and acting on this absence of edge as an investor is a key premise of the investment methods suggested in my recent book “Investing Demystified” (Financial Times Publishing), and something I believe is critical for all investors to understand.

Consider these two investments portfolios:

  1. S&P 500 Index Tracker Portfolio like an ETF or index fund.
  2. A portfolio consisting of a number of stocks from the S&P 500 – any number of stocks from that index that you think will outperform the index.  It could be one stock or 499 stocks, or anything in between, or even the 500 stocks weighted differently from the index (which is based on market value weighting).

If you can ensure the consistent outperformance of portfolio B over portfolio A, even after the higher fees and expenses associated with creating portfolio B, you have edge investing in the S&P500.  If you can’t, you don’t have edge.

At first glance it may seem easy to have edge in the S&P500.  All you have to do is pick a subset of 500 stocks that will do better than the rest, and surely there are a number of predictable duds in there.  In fact, all you would have to do is to find one dud, omit that from the rest and you would already be ahead.  How hard can that be?  Similarly, all you would have to do is to pick one winner and you would also be ahead.

Although the examples in this piece are from the stock market, investors can have edge in virtually any kind of investment all over the world.  In fact there are so many different ways to have edge that it may seem like an admission of ignorance to some to renounce all of them.  Their gut instinct may tell them that not only do they want to have edge, but the idea of not even trying to gain it is a cheap surrender.  They want to take on the markets and outperform as a vindication that they “get it” or are somehow of a superior intellect or street-smart.  Whatever works!

The Competition

When considering your edge who is it exactly that you have edge over?  The other market participants obviously, but instead of a faceless mass, think about whom they actually are and what knowledge they have and analysis they undertake.

Imagine the portfolio manager of the technology focused fund for a highly rated mutual fund / unit trust who like us is looking at Microsoft.  Let’s call them Ability Tech and the fund manager Susan.

Susan and Ability have easy access to all the research that is written about Microsoft including the 80 page in-depth reports from research analysts from all the major banks including places like Morgan Stanley or Goldman Sachs that have followed Microsoft and all its competitors since Bill Gates started the business.  The analysts know all of the business lines of Microsoft, down to the programmers who write the code to the marketing groups that come up with the great ads.  They may have worked at Microsoft or its competitors, and perhaps went to Harvard or Stanford with senior members of the management team.  On top of that, the analysts speak frequently with the trading groups of their banks who are among the market leaders in the trading of the Microsoft shares and can see market moves faster and more accurately than almost any trader.

All research analysts will talk to Susan regularly and at great length because of the commissions Ability’s trading generates.  Microsoft is a big position for Ability and Susan reads all the reports thoroughly – it’s important to know what the market thinks.  Susan enjoys the technical product development aspects of Microsoft and she feels she talks the same language as techies, partly because she knew some of them from when she studied computer science at MIT.  But Susan’s somewhat “nerdy” demeanour is balanced out by her “gut feel” colleague, who see bigger picture trends in the technology sector and specifically sees how Microsoft is perceived in the market and ability to respond to a changing business environment.

Susan and her colleagues frequently go to IT conferences and have meetings with senior people from Microsoft and peer companies, and are on first name basis with most of them.  Microsoft also arranged for Ability to visit the senior management at offices around the world, both in sales roles and developers, and Susan also talk to some of the leading clients.

Like the research analysts from the banks, Ability has an army of expert PhD’s who study sales trends and spot new potential challenges (they were among the first to spot Facebook and Google).  Further, Ability has economists who study the US and global financial system in detail as the world economy will impact the performance of Microsoft.  Ability also has mathematicians with trading pattern recognition technology to help with the analysis.

Susan loves reading books about technology and every finance/investing book she can get her hands on, including all the Buffett and value investor books.

Susan and her team know everything there is to know about the stocks she follows (including a few things she probably shouldn’t know, but she keeps that close to her chest), some of which are much smaller and less well researched than Microsoft.  She has among the best ratings among fund managers in a couple of the comparison sites, but doesn’t pay too much attention to that.  After doing this for over twenty years she knows how quickly things can change and instead focuses on remaining at the top of her game.

Does Susan have edge?

Do you think you have edge over Susan and the thousands of people like her?  If you do, you might be brilliant, arrogant, the next Warren Buffett or George Soros, be lucky, or all of the above.  If you don’t, you don’t have edge.  Most people don’t.  Most people are better off admitting to themselves that once a company is listed on an exchange and has a market price, then we are better off assuming that this is a price that reflects the stock’s true value, incorporating a future positive return for the stock, but also a risk that things don’t go do plan.  So it’s not that all publicly listed companies are good – far from it – but rather that we don’t know better than to assume that their stock prices incorporate an expectation of a fair future return to the shareholders given the risks.  We don’t have edge.

When I ran my hedge fund I would always think about the fictitious Susan and Ability.  I would think of someone super clever, well connected, product savvy yet street-smart who had been around the block and seen the inside stories of success and failure.  And then I would convince myself that we should not be involved in trades unless we clearly thought we had edge over them.  It is hard to convince yourself that this is possible, and unfortunately even harder sometimes for it to actually be true.

Investing without edge

For someone to accept that they don’t have edge is a key “aha” moment in their investing lives, and perhaps without knowing it at first, they will be much better off as a result.  At this point you are hopefully at least considering a couple of things:

  1. Edge is hard to achieve and it is important to be realistic about if you have it.
  2. Conceding edge is a sensible and very liberating conclusion for most investors.  It makes life lot easier (and wealthier) to acknowledge that you can’t better the aggregate knowledge of a market swamped with thousands of experts that study Microsoft and the wider markets.

Once you have conceded edge you are unfortunately not done.  In fact you have only arrived at the starting point and started your journey as an investor who has conceded edge.  There is every change that you will be a far wealthier investor as a result of this.

For the edgeless investor it makes sense to pick the most diversified and cheapest portfolio of world equities and combining that with some government and potentially corporate bonds through cheap index tracking products that suit your risk and tax profile.  Do this while considering your non-investment assets/liabilities, time horizon of investment, and a few other things, and you are doing extremely well.  Once you embrace that you don’t have edge it is fortunately pretty intuitive and really not that difficult to put together a simple and powerful investment portfolio.

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Lars Kroijer is the author of Investing Demystified – How to Invest Without Speculation and Sleepless Nights from the FT Press.  You can follow him @larskroijer.

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