Eyes on the horizon
Your investment edge
Years ago, when my job involved selecting investment managers for my clients’ portfolios (yep, I was also once an allocator), one of the questions I would ask every manager was “What is your edge?”
The big money managers have all of the PhDs and global analyst teams. They are fully stocked with all sorts of proprietary analytics. They pay for exclusive information designed to give them insights into what’s going on in the economy and the industries they cover. But most of them have performance that hovers around the averages.
Why is this?
An investing edge is ephemeral. One day it’s there, the next day it’s gone. Once a certain investment style has made a lot of money, it attracts more practitioners. The more people who are out there pursuing a strategy, the more it works… until it doesn’t. At a certain point, everyone who is going to implement the strategy has already done so. And with no new money coming in, the only direction for prices to go is down. It is extraordinarily difficult to sustain outperformance based on a perceived investment edge.
So, as an individual investor, what’s your edge?
I’m about to reveal it to you—and it’s not based on any complicated formulas or proprietary data. It’s easy to understand and will persist over time.
Your edge is that you don’t care how your portfolio does in the near term.
Well… you shouldn’t care how it does in the near term.
And so if you do care what it’s doing today, this week, this month, or this quarter, then you’re giving up your one and only edge over the pros.
To illustrate, I’ll explain to you how most big money is invested. It is “overseen” by a board or committee, which receives a quarterly report from a consultant. These consultants comb over the decisions of portfolio managers in the context of explaining why each segment of the portfolio performed as it did relative to its benchmark in the past quarter.
There’s nothing magical about the calendar quarter, but these arbitrary beginning and endpoints become the focus of the committee’s analysis. The consultant will explain which stocks or sectors each manager should have owned, or which ones they should have avoided, in order to have performed better. One quarter the portfolio manager will be praised for owning a company, and the next quarter they will be criticized for it. It all depends on what “the market” decided to do during this past arbitrary three-month period.
Money managers playing this game can feel like a dog chasing its own tail. Obsessing over short-term performance is a losing game, and yet consultants and boards continue this pattern, if only out of habit, reinforcing the same tendency.
What’s at stake for the portfolio managers in this game is nothing less than their livelihood. If a particular firm underperforms for long enough, consultants will recommend that clients pull their money out. If enough clients depart, it will impact the portfolio manager’s bonus, and eventually job security. And so, due to these incentives, a myopic fixation on short-term performance is endemic in the investment industry.
Nitpicking portfolio performance each and every quarter is a horrible way to invest. But it’s what most of the big money out there is doing.
So the way the investment managers deal with this is to give the consultants what they want. If 5 percent of the benchmark is a piece-of-shit, overpriced stock, the manager will express their displeasure by only allocating 4 percent of your portfolio to that piece of shit. Sounds nuts, but if that particular stock has been going up recently, the manager would prefer to have some allocation to it in order to avoid the indignity of an extended period of underperformance.
Yes, it’s stupid. We know it’s stupid. Many investment firms simply refuse to play this game, at the cost of disqualifying themselves from the institutional allocator beauty pageant.
Your edge, investing your own capital, is that you can refuse to play it as well.
You can invest in stories that evolve over years, not months or quarters. Consequently, the game actually becomes easier to play.
Tracking every small short-term movement in the stocks you own works against you and serves to dull your investment edge.
Hiring a consultant or allocator to watch over the minutiae of the trades of your managers and reporting back to you every quarter will give you a sense that someone is “watching over” your money, but in the long run it won’t add even a bit to your long-term returns. In fact, it’s likely to do the opposite.
Your investment edge over the professionals and institutions is that you can afford to ignore the short term. You don’t care if you underperform a benchmark index for a while, as long as you preserve capital. So while others avoid out-of-favor companies and industries, you can accumulate shares with patience, knowing that it will eventually pay off. While everyone else is fretting over the headlines and worried about this quarter’s earnings, you’re looking several years down the road. Keep your eyes on the horizon and you’ll find that you’ve got an edge over even the largest and most well-resourced investors.
