The second idea to improve your investment process – if you have not already done so – is to carefully define it in writing. As investors, by default we all have some type of investment process. Some are good and some are not so good. Some are thoughtfully constructed, some are not.
All of them can be improved through focused effort.
If you haven’t done so already, you should commit your process to writing – not just your general philosophy – but all aspects of your process: your search strategy, research and valuation methods, portfolio management, sell strategy, everything – and then work like crazy to improve it. If you don’t write it down, you can’t study it, tweak it, improve it, and develop it.
WHAT’S YOUR EDGE?
To have a good investment process, you need to answer the question, “What’s my edge?” Investing is highly competitive, and you have to assume that the person on the other side of the trade is intelligent and well-informed.
Michael Mauboussin talks about three types of edge: analytical, psychological and institutional.
First, let’s consider an analytical edge. Mauboussin explains that you can think of it as the ability to recognize a gap between the fundamentals and expectations. For example, consider horse track betting. The fundamentals are the speed of the horses or the records of the jockeys. The expectations are the odds and the payouts. Having an analytical edge means being able to skillfully handicap the race and see valuation gaps between the fundamentals and expectations.
How do you get an analytical edge? You could focus on one industry or sector, perhaps where you have specialized knowledge or experience. Or, you could focus on complex situations that are hard to understand. Perhaps you could gain an edge by focusing on micro or nano-cap stocks with little or no analyst coverage.
You might want to focus on securities that have shown persistent outperformance, such as special situations. You could look for time arbitrage opportunities where the market is overreacting to recent events and undervaluing a business’s long term prospects.
Don’t underestimate the knowledge and expertise it takes to gain an analytical edge in today’s highly competitive market. The required skill is similar to that of a medical specialist or skilled attorney.
Charlie Munger tells the story of Max Plank traveling around Europe lecturing after he won the Nobel Prize. Apparently he gave the same speech so many times that his chauffer memorized it. To amuse themselves, so the story goes, Plank would have the chauffer occasionally give the speech. During the Q&A that followed, if someone asked a question that the chauffer couldn’t answer, he would retort, “My good man, I’m surprised you would ask such a simple question in a sophisticated European city. I’m going to have my chauffer answer that one.”
We need to avoid chauffer knowledge like the plague when pursuing an analytical edge. Simply regurgitating someone else’s thesis is to have no edge at all.
Another type of edge is a psychological edge. One form of having a psychological edge is having the emotional discipline to exploit fear – to step up when others are in a state of panic. Another form of psychological edge is having the patience to wait for obviously attractive opportunities. Also, you might seek an edge in how you run your portfolio by placing large bets on your high-conviction ideas. This is how some of the most successful investors run their portfolios.
Professional poker players only bet in size when the odds are favorable. If you don’t know your edge, you can’t assess when the odds are in your favor. If you invest anyway, you’ll make yourself the patsy and the outcome is much less likely to be positive.
Finally, a word about having an institutional edge.
If your money is managed by a professional money management firm, you will have an edge if they truly put your interests first. How do you know? Do they eat their own cooking? That is, is a substantial part of their net worth in the fund? Are their fees fair? Will they close the fund if it gets too large or are they more interested in harvesting assets? Do they look like a closet index fund or do they have a process that adds real value? Pay close attention and focus your investments with managers who adhere to these principles.