One of the best books a new investor can read is Investing Demystified by Lars Kroijer. Lars, a Harvard-educated Dane, based in London, was for many years a successful hedge fund manager. But during that time he saw at first hand how very hard it is, even for well-resourced, to beat the market after costs, and he became convinced that the best option by far for a typical investor is to invest, for the long term, in a simple, low-cost index fund portfolio.
In the book, he explains the reasoning behind this approach, and how to implement it, and I’m very grateful to Lars and to FT Publishing for allowing me to serialise it on TEBI.
I strongly urge you to buy the book, which you can do via Lars Kroijer’s website. The second edition of the book is due for publication next year.
In the first extract, Lars explores what it means to have an edge over the markets — and how to work out whether or not you have one.
What is an “edge” over the markets — and do you have it?
The following is an extract from Investing Demystified by Lars Kroijer. It is serialised here with the kind permission of the author and FT Publishing.
A key premise of this book is that we can’t legally beat the markets consistently, or indeed know of an investor that can. It concedes having an edge over the markets. But what is meant by this?
Consider these two investment portfolios:
Portfolio A: The S&P 500 Index
Portfolio B: 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 gained an edge by investing in the S&P 500. If you can’t, you don’t have an edge.
On first glance it may seem easy to have an edge over the S&P 500. 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.
While the examples in this chapter are from the stock market, investors can have an edge in virtually any kind of investment. In fact there are so many different ways to have an edge that it may seem like an admission of ignorance to some to renounce all of them. Gut instinct may tell investors that not only do they want to have an edge, but the idea of not even trying to gain it is a cheap surrender. They want to take on the markets and outperform to make money, but perhaps also as a vindication that they ‘get it’, are street smart or somehow have a superior intellect.
When considering your edge who is it exactly that you have an edge over? The other market participants obviously, but instead of a faceless mass think about who they actually are, what knowledge they have and what analysis they undertake.
Imagine Susan, the portfolio manager of a technology-focused fund working for a highly rated mutual fund/unit trust (let’s call it Ability) who like us is looking at Microsoft.
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 Morgan Stanley and Goldman Sachs, that have followed Microsoft and all its competitors since Bill Gates started the business. The analysts know all Microsoft’s business lines, 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 their banks’ trading groups who are among the market leaders in trading 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 that 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’ colleagues, who see bigger picture trends in the technology sector and specifically how Microsoft is perceived in the market and its 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 a first-name basis with most of them. Microsoft also arranged for Ability personnel to visit its senior management at offices around the world, both in sales and development, and Susan also talks to some of Microsoft’s leading clients.
Like the research analysts from the banks, Ability has an army of expert PhDs 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 affects Microsoft’s performance. 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 is one of the best-rated fund managers in a couple of the comparison sites, but doesn’t pay too much attention to that. After doing her job for over 20 years she knows how quickly things can change and instead focuses on remaining at the top of her game.
Do you think you have an 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, lucky or all of the above. If you don’t, you don’t have an 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 their stock prices incorporate an expectation of a fair future return to the shareholders given the risks.
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 knew 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 an edge over them. It is hard to convince yourself that this is possible, and unfortunately even harder sometimes for it to be actually true.
Picking your moment
Warren Buffett is quoted as saying that ‘just because markets are efficient most of the time does not mean that they are efficient all of the time’. To quote Buffett about investing is like quoting Tiger Woods about golf. He is a world-famous investor with a long history of being right, so we are all bound to feel a little deferential.
Buffett’s words might be right of course. Markets might be perfectly efficient some or even most of the time and horribly inefficient at other times. But how should we mere mortals know which is when? Can you predict when these moments of inefficiency occur or recognise them when you see them? Clearly we can’t all see the inefficiencies at the same time or the market impact of many investors trying to do the same thing would rectify any inefficiency in an instant. But can you, as an individual investor, spot a time of inefficiency?
I think that it’s incredibly hard to have an edge in the market even occasionally. Be honest with yourself. If you have a long history of picking moments when you spotted a great opportunity, moved in to take advantage of it and then exited with a profit, then you may indeed occasionally have an edge. You should use this edge to get rich.
The costs add up
On average individual investors trying to beat the markets would not systematically pick underperforming stocks – on average they would pick stocks that perform like the overall market. They would have a sub-optimal portfolio that would not be as well diversified, but in my view the main underperformance comes from the costs incurred.
The most obvious cost when you trade a stock is the commission to trade. This has been lowered dramatically with online trading platforms but it is far from the only cost. A few others to consider are:
- bid/offer spread
- price impact
- transaction tax
- information/research cost
- capital gains tax
- transfer charge
- custody charge
- advisory charge
- your time.
Depending on your circumstances and portfolio size you may find that it costs more than 1% each time you trade the portfolio (the low, fixed, online charge per trade is only a small commission percentage if you trade large amounts), excluding the cost of your time. This is certainly less than it used to be decades ago, but for someone who is frequently trading their portfolio it will be a major obstacle to performance. In addition, capital gains tax amounts can add up for frequent traders and the ‘hidden fees’ like custody or direct or indirect costs associated with research and information-gathering come on top. The more this adds up to, the greater the edge someone will need just to keep up with the market.
I recently saw a particularly cringeworthy advertisement where a broker compared trading on its platform to being a fighter pilot, complete with Tom Cruise style Ray-Ban sunglasses and an adoring blonde. I remember thinking, ‘I would love to sell something to whoever falls for that.’ The platform makes more money the more frequently you trade, and the broker obviously thinks that you will trade more if you believe it’ll make you be like Tom Cruise.
How you cost your time spent managing your portfolio is individual to you (we each value our time differently) and while some consider it a fun hobby or game akin to betting, others consider it a chore they would rather avoid. Someone may spend 10 hours ‘work time’ a week on their portfolio which at an ‘opportunity cost’ of time of $50 an hour for 40 weeks is $20,000 a year on top of all the other costs discussed. This clearly makes no sense for a $100,000 portfolio and is too costly even for a $1 million portfolio. On top of everything else this investor would benefit from the reduced time involved in running a simple rational portfolio. Also consider that it is only the outperformance you get paid for. Since owning an index tracker takes no time, the cost of time — $20,000 above — actively managing your portfolio is only for the amount you beat the index by. If the index is up 10% and you are up 11% then it is only the 1% excess return that you spent all that time to make. So even in the very unlikely case that you can consistently beat the index you either have to be able to beat it by a lot, or manage a large amount of capital for the time spent to be worth it.