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How to Find an Edge
I’ve been writing for some months now and reading a considerable amount of, everything, basically. All about the same topic, the stock market. I mentioned in the last article that I’m now going through all Warren Buffet shareholder letters since 1957. I currently stand on 1981, would love to read much more, but the University and the writing are kind of limiting my reading.
Anyway, along the pages, I encountered Warren indirectly trying to answer a question that has been driving me crazy for almost ever. With his help, I think I’m getting closer to the answer. This is an interrogative every investor must face if he truly wants to transcend vague and average performance.
Is finding an edge possible?
Before tackling down the actual concern that brings us here, we must first try to establish if there’s any possibility of an edge existing. If there’s not, it makes no sense for an investor to try to find it.
There have always been many reasons to believe that finding an edge is not possible. If we go a bit back in history, to 1965, there was even a theory that was created, known by almost any person involved in finance: “The Efficient Market Hypothesis”
I wrote about this a few months ago, in case you are interested:
Anyway, this hypothesis claims that all agents act rationally and that assets reflect all information available in their prices, turning impossible the task to beat the market on a risk-adjusted basis. This theory has been around for some time and it’s literally taught in many universities. All of this creates an aura of uncertainty around the topic, ending with most people quoting the theory and calling it a day.
However, as time went by, there were many outliers, not a few of them. Multiple investors, under many different circumstances were able to outperform the market consistently. People like Benjamin Graham, Warren Buffet, Peter Lynch, Francois Rochon, Nick Sleep, and more, have shown the task is achievable. From long-term investors, to traders like Mark Minervini, to algorithmic trading like James Simons. Such cases give room to the possibility of an actual edge to exist.
How to find it?
I must admit the hypothetical answer has not arisen from nowhere. As aforementioned, it was inspired by the reading of Buffet and I wrote about it, as a section, on last article, as forming part of the very basis of Warren’s strategy: The importance of thinking for oneself.
I find myself continuously exposed to people’s thoughts about the stock market, either via Twitter or articles written on different platforms, videos, books. It is noticeable how the bias of ‘social proof’ is seen all across the board. People generally do not disagree with the crowd because they probably believe, at an unconscious level, it is in the crowd where truth relies.
However, it has been historically proven by the markets that the crowd tends to underperform the different indexes. The image below showcases investors’ performance over a 20yr period against different assets and inflation.
The underperformance the average investor has is noticeable. Therefore, if one shall commit himself to the same premises as the crowd, his performance should tend to the same results. And that’s where the key is.
90% of people underperform the markets. Even though the efficient market hypothesis has been proven wrong, that does not mean there’s not any truth in it. I encourage you to read the article I put above, ‘The Collective Wisdom’, for in it will I base my thought.
My hypothesis in trying to address the question is the built upon the discussed bias, social proof. The general public does not have alpha because, what the general public thinks, is almost guaranteed to be priced into each stock. Consequently, by following other people, you will always tend to underperform because you would be always operating under already known and priced information.
So, there’s the answer to the question, which I have already stated. I’m quoting Naval (I believe) here:
“Escape competition through authenticity.”
In other words, think for yourself and trust and work upon your facts and reasoning to improve. It’s within the process of each person’s thinking when investors can detach from the average and, at the same time, the average performance. It is not an easy task, but it is exactly the task we are tackling with this Newsletter. I’ll copy-paste a paragraph I wrote last week:
“Perhaps I’m incorrect with the following, but he seems to believe that the only way to get rid of index-like performance is to think and evaluate upon thoughts, measures, hypothesis and facts. It is key though to be a consistent thinker because, if not, the tendency towards index-like performance is inevitable” Me
“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you” Buffet, Jan 1962
I hope you enjoyed today’s article. I was thinking on not writing one because of how much time I’m currently dedicating to writing earning reviews and companies’ research. But I find these kinds of articles to be therapeutic in some sense and I always end up feeling somewhat wiser than when I start them, I hope the same happens to you.
On Wednesday, I’ll be publishing Visa’s deep dive. Also, I believe I will be publishing a general review of Large Tech Earnings. If you do not want to miss them nor fundamental articles like today’s, feel free to subscribe below.
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