Building an edge

In an earlier note, I wrote about the three factors which contribute to outperformance (doing better than an index). I expanded on the third factor in the most recent update.

Sources of outperformance
Superior performance versus the indices can usually be broken down into three buckets

a.     Informational edge – An investor can outperform the market by having access to superior information such ground level data, ongoing inputs from management etc.

b.     Analytical edge – This edge comes from having the same information, but analyzing it in a superior fashion via multiple mental models

c.     Behavioral edge – This edge comes from being rational and long term oriented.

I personally think our edge can come mainly from the behavioral and analytical factors. The Indian markets had some level of informational edge, but this edge is eroding with wider availability of information and increasing levels of transparency.

We aim to have an analytical edge by digging deeper and thinking more thoroughly about each idea. Ultimately it, depends on my own IQ levels and mental wiring, which is unlikely to change despite my efforts.

The final edge – behavioral is the most sustainable and at the same the toughest one to maintain. This involves being rational about our decisions and maintaining a long term orientation. If you look at the annual turnover of mutual funds and other investors, most of them are short term oriented with a time horizon of less than one year. In a world of short term incentives, an ability to be patient and have a long term view can be a source of advantage.

An enormous advantage

We started the advisory in 2011. At the outset, we made a few decisions which has made our life simpler and saved us a lot of pain.

-    We will not tout the wins on social media, which are often due to luck and can easily get hit by a random event causing a loss for anyone trying to follow them. If it works well, the person taking the tip attributes it to their genius. If it fails, we are responsible. Considering that the best of investors don’t get it right more than 60-70% of the time, what is the upside other than an occasional ego trip?
-    We will focus on the investment process as that is the only repeatable aspect of investing over which we have some control. We cannot control the outcome.
-    We will focus on the long term as short-term results are prone to random events, but the noise cancels out over time
-    We will not indulge in making fun of other investors when we are doing well. It is stupid behavior and extremely petty. There are times when every investor goes through a bad patch – so what goes around comes around

Some of the behavior we see in the media, although loud, petty and promotional is not irrational. It allows the advisor/ fund manager to get visibility and increase their AUM. In the end, managing a fund is a business and one cannot live on high ideals alone.

The problem with this behavior is the type of investors you attract. If you talk about short term performance and multi-baggers, then you will attract people looking for quick gains and easy profits. The downside of having such investors, is that  they get quickly disappointed when the inevitable downturn hits the market.

Looking for quick gains, such investors join at the top and manage to get quick losses.

For the fund manager, there is no downside. If the market keeps going up, they get to make their fees. If the market drops and they lose a few investors, which is part of the normal business cycle. They just need to wait for the next bull market for a new crop of performance chasers.

Both me and Kedar don’t want to play this game. We are not running this advisory for the good of mankind, but do not like this behavior. In addition, we are in a financial position, where we do not depend on the fees we earn to put food on the table.

Why am I sharing this now after so many years?

The reason for sharing is that a person cannot be rational and make decisions for the long term if that results in career risk. Try telling your family that you took a 5-year view which cost you your job. It is never going to happen.

We have taken this element of risk out of the equation for us. As I mentioned earlier – we do not depend on the advisory to put food on our table. In addition, our own money is invested in the same way as the model portfolio. Put the two together and you will realize that we are willing and able to think long term with a focus on risk reduction.

I think this is a very important edge for us compared to most fund managers. We can safely ignore short term fads (such as the bull market in small and mid-caps last year) and panics and rationally manage the portfolio. This allows us to take bets which are unpopular and hold on to them.

In an age of huge computing power and easily available information, one is unlikely to get a durable analytical or information edge over other investors. However, the third edge – behavioral which is durable and cannot be competed away, is available to us due to the reasons I have shared.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.