Making the most of an investment edge
Peter Elston, CIO at Seneca Investment Managers, reflects on the fact that investment success, very much like skill or luck games, depends on understanding your edge and profiting from it.
Whether in skill games like Poker or luck games like Blackjack, repeatable success requires tilting the odds in your favour, then betting the appropriate amount as a percentage of your bankroll. In Blackjack, the way to tilt the odds towards you, and thus away from the house, is by counting cards (this however is considered cheating by casinos, so I wouldn’t recommend it). In Poker, you and your fellow players are on an equal footing, so to tilt the odds in your favour you just need to be better than them. You do this by having a better strategy or being better at bluffing or calculating probabilities (or a combination of all three). As for the percentage of your bankroll to bet, this relates directly to the extent to which you have tilted the odds in your favour.
What this all adds up to is understanding your edge and profiting from it. Investment success works very much in the same way.
The efficient market hypothesis says that stocks follow a random walk. Once transaction fees are taken into account, the odds are tilted away from you and it thus becomes practically impossible to beat the market. However, if this were true the likes of Warren Buffett and Renaissance Technologies’ Jim Simons should not exist. Except they do and, statistically speaking, the likelihood of their high investment returns being attributable to luck is so small that it is practically zero. What they both did, and in very different ways, was to tilt the odds in their favour. In other words, they had an edge and put it to good use.
Buffett’s edge, in my humble opinion, has been his extraordinary understanding of human nature, both its strengths (what it takes to build a great company) and its weaknesses (propensity for humans to be greedy or to panic) combined with discipline, patience, honesty and a very good grasp of statistics and probabilities. Jim Simons, on the other hand, is a brilliant mathematician and has a smarter and faster computer than anyone else. While Buffett is the king of predicting share prices over 10 years, Simons is unrivalled over 10 minutes. All active investing, after all, involves making predictions.
It is clear that Buffett and Simons are rare birds, yet many still believe themselves to be good investors when the facts tell a different story. The reason for this is that we humans evolved a survival mechanism to believe that we are better than we are. Let’s face it, a timid approach to facing down a sabre-toothed tiger or attracting a cave mate would not have met with much success. Furthermore, we have an asymmetrical capacity to blame our failures on (bad) luck but to attribute our successes to skill, known as the fundamental attribution error. Thus, you only need a couple of successes amongst all the failures to think that you’re a skilful investor!
However, let’s assume that you do in fact have an edge, in which case you need to know how to use it.
Question: if you have a biased coin that you know has a 60% chance of landing heads and you are playing ‘toss’ with someone who does not know the coin is biased, what percentage of your bankroll should you bet each round in order to grow your wealth at the fastest possible rate over time?
If you bet nothing, you’re wasting your edge (you know, he doesn’t) and your wealth will remain the same.
If you bet your entire purse, there’s a 40% chance the coin will come up tails, and you’ll lose everything and be out of the game (even with the bias, the chance of there being one tail in 10 tosses is 99%).
To state the obvious, the optimal percentage therefore must be somewhere between 0% and 100%. The answer, in fact, is 20%. Bet 21% or 19% and over time you’ll end up less wealthy than if you bet 20% (if you want to know more about the calculations involved in this, google the term "Kelly betting criterion" or read William Poundstone’s excellent book, Fortune’s Formula).
How does this apply to investing?
In Buffett’s case, he naturally understands that to put all one’s eggs in one basket is foolish, but also that being overloaded with baskets, as it were, will wear you out. Modern portfolio theory says you should diversify as much as possible to eliminate stock specific risks. Buffett on the other hand actively seeks out stock specific "risk" because he knows that's where he has an edge. His comments "Wide diversification is for people who don’t know what they’re doing" and (on the efficient market hypothesis) "If you're in shipping it helps if your competitors believe the world is flat" are two of my favourites.
Does Buffett know precisely what his odds are? Of course not. What he does know is that he has a good feel for where a company will be in 10 years' time, giving him the confidence to run concentrated portfolios.
It seems in recent years to have become passé to cite Warren Buffet. This is a shame, as there is still much we can learn from him.
Issued by Seneca Investment Managers
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers Limited and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment. Seneca Investment Managers Limited (0151 906 2450) is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP19 100