When we make an active investment decision, we obsess over the particulars of a given opportunity, whether it be a security, fund or asset class. This, however, distracts us from a far more important issue, which is so often ignored – should we be participating in the activity at all? This must always be our starting point. To make it so, we need to ask ourselves these questions:

– What are the odds of the game?

The critical first step is establishing the odds of the game we are playing. We want to engage in an investment activity where the odds are in our favour, or at least more in our favour than in other games. The major mistake we tend to make is grossly overstating our chances of success due to overconfidence in our abilities. To paraphrase Charlie Munger, who cares that 90% fail when I am in the 10% that succeeds?

The best means of guarding against such biased thinking is to assume that we are average. Rather than ask how likely is it that I will be successful, ask how likely is it that any given person will be (you never know, we might even be average ourselves). This approach gives us a reasonable base rate or starting point.

– Do I have an edge?

Once we have established a satisfactory estimate of the odds of success in an activity, we need to gauge whether we have an advantage relative to the average participant. If we are going to engage in a game with terrible odds, we are either ignorant of them, playing for fun (like a trip to Las Vegas) or believe there is something about our approach that puts us in the 10%. 

For professional investors, there is one additional reason that we might play a game with a low probability of success – because the cost of participating is borne by somebody else. The chance of positive (lucrative) outcomes for a fund manager are often significantly greater than it is for their clients.

The worse the odds, the more conviction we must have that we have some form of advantage. 

– What is the edge?

It is not enough to believe we have an edge; we must be clear about what it is and why it might exist. For most active investors, an advantage can be categorised as informational (we have better information than others), analytical (we use that information in a superior way to others) or behavioural (we exploit the decision-making shortcomings of others).

It is often argued that financial markets are more informationally efficient than ever before. There is more data, greater transparency and less friction. Making a case for an information-based advantage (in most major asset classes) seems a somewhat heroic assumption. Analytical edges are possible but incredibly difficult to substantiate. Where an analytical advantage arises, it is probably not from the ability to synthesise information better but to use it for a different purpose. Are we trying to predict next quarter’s EPS for a business or its long-run value?

Most market inefficiencies stem from the vagaries of human behaviour. It is difficult to argue that investor behaviour is becoming more rational, and certainly possible that things are getting worse. There is a problem with a purported behavioural edge, however. Not only do we have to contend that other investors are irrational, but that we are not. We are somehow free from the psychological and institutional burdens that lead to poor decisions. This is far easier to say than do.

– Who am I playing against?

In zero-sum games, the ability of the other participants matters a great deal. My chances of winning at poker heavily depend on who else is sitting at the table. Investing is similar but different.

It is undoubtedly true to say that having sophisticated, well-resourced investors facing off against each other is not a great environment to find an edge. Yet there is a major difference between poker and investing. In poker, everyone is playing with the same objective; in investing, this is not the case. Even though it feels like it. If I have a twenty-year investment horizon (if only) and other participants take a one-year view, we are barely playing the same game. At best, we are playing the same game with very different rules. So, the question becomes not – who am I playing against? But – what is it they are playing, and why am I able to do something different?

A painful confluence of compelling stories and inescapable overconfidence means that we are prone to participate in investment activities where the chances of positive results are very poor. To guard against this, we need to better understand the odds and justify why we might be an exception.  

—

My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).