“If you know the enemy and know yourself, you need not fear the result of a hundred battles”
Sun Tzu
Before The Battle of Agincourt, English forces were in a bleak position.
A depleted army, led by Henry V, had spent two and a half weeks marching 260 miles through the French countryside. Many in their ranks had been struck down by illness, there was very little food left and to top it all off the English were greatly outnumbered by their enemy - possibly by as many as five to one.
The French army were regarded as one of the most powerful in Europe at the time, an estimated 12,000 knights protected by full plate mail and armed with swords and maces. Charging their enemy atop large powerful horses, bred for combat, they were a formidable force.
But against massive odds, in one of the great historic military victories, the English prevailed.
While the French were unequivocally better resourced in terms of manpower and were on home soil, the English made sure to maximise what few advantages that they had available to them.
The longbow which English archers carried provided further range and accuracy than the crossbows that the French held. This meant that the English could land the first blows in combat. As battle commenced, English archers rained down arrows on the advancing French ranks causing large losses and panic.
The battle also took place on a favourable piece of terrain from the English perspective. The land, hemmed in by dense woodland, forced the French forces through a narrow area and made it easier for the English archers to inflict maximum damage.
The battleground itself was situated on a recently ploughed field, which due to heavy rainfall had become very muddy. French troops, clad in full plate armour, were simply too heavy for the conditions. They sank into the mud and made for easy targets during the English counter attack. The counter attack that scattered the French threat, and brought the battle to an end.
History is littered with examples of occasions where an underdog bites back and defeats the favoured foe. David and Goliath. Buster Douglas and Mike Tyson. Will Young and Gareth Gates.
On further analysis of each case, although the “favourites” undoubtedly made mis-steps, the less fancied party made damn sure that they were operating at their best when the time came. They played to their strengths.
The global stock market is where millions of buyers and sellers come together to trade the shares of the biggest companies on the planet. These market participants range from you and I, individual retail investors, to the world’s largest hedge funds.
While in many ways we are playing a uniquely individual game, trying to earn a return on our money that allows us to achieve our own individual objectives, there is no denying that there are two counterparties to every trade. Each party taking a differing view on a given security.
So I guess that you could say every market participant is locked in a kind of ongoing combat with everyone else.
Like in any contest, there are a number of different ways to win. In this game, I would suggest that there are broadly three different kinds of “edge” or advantage available to each market participant.
In a bid to identify how we can best play to our strengths, let’s have a look at each of these edges.
Informational Edge
The most intellectually compelling and glamorous of the three. By undertaking many painstaking hours of thorough research on a given company, you have endowed yourself with a better knowledge of the company’s prospects than your fellow market participants.
Congratulations, you have an informational edge.
Equity analysts at the largest investment banks and research firms globally spend their entire careers diligently working to gain the slightest of an informational edge into the securities that they cover. These are incredibly intelligent people, working for some of the best resourced companies on the planet, and it is their day job to know these companies inside and out.
That is who is sitting across the poker table from you. This is your enemy.
However, despite the massive amount of cash and brainpower that the investing industry throws at gaining an informational edge, there is more than a little evidence to suggest that the predictions made by professional equity analysts are woefully inaccurate.
Using a database of all U.S. company stocks from 1997 to 2021, Brian Chingono and Greg Obenshain of Verdad measured the median analyst estimate for earnings growth within these companies over the next two to three years. They then compared these analyst forecasts with the actual median outcomes produced by the relevant companies over the next two to three years.1
As you can see from the below, analysts consistently overestimated the actual earnings that these companies would come to generate.
Not to be too blunt, but if the best in the world can’t get it right then what chance do you and I have sat at our kitchen table reading The Motley Fool? Chasing an informational edge is like trying to catch smoke.
Execution Edge
If you haven’t read Michael Lewis’ Flash Boys, I’d give it a go. It isn’t his best in my humble opinion, but it is a very decent read.
The book describes the lengths that professional investment firms will go to in order to gain an edge in execution. Using “high frequency trading” to ensure that they can be the first to react to a given piece of news about a stock, and take advantage before others do.
In the first chapter, we read of the construction of a $300 million, 827 mile fibre optic cable running from Chicago to New Jersey. The cable is laid by a company called Spread Networks, whose customers are all so-called high frequency trading firms.
It is estimated that this new line allows the connected firms to receive trading information four milliseconds quicker than they previously had.
Even if you spend all day and all night sat by your computer waiting to trade off the back of whatever news you deem relevant about a stock - you are bringing a spoon to a gun fight.
Behavioural Edge
Regular readers will be unsurprised to hear that this is where I feel that retail investors should focus their attention.
The easiest way to win is by trying to play your own game. Getting sucked into side quests, scuffling with others in a meaningless bid to show how clever we are - this is not the path to success.
By adopting a sensible, time proven investment strategy and letting nothing deflect us from our course we maximise our chances of victory. To paraphrase Sun Tzu, the best victories are achieved without trading. Or something.
Every time we tinker with our portfolios, every time that we try to chase a little of "what is working today" we leave ourselves vulnerable to error, to counter attack.
“The stock market is designed to transfer money from the active to the patient”
Warren Buffett2
Of course, it is easy to say and difficult to do. Especially given that we have all been conditioned since childhood to associate effort with outcome. The harder I try, the more I do, the more likely I am to be “successful”.
Investing doesn’t work like that. If I try harder, I am just likelier to get in my own way and to trip over my own feet. Doing nothing can feel counter-intuitive, uncomfortable even, but there is often an inverse correlation between activity (effort) and returns.
Over the Bank Holiday weekend, I was at a barbecue with some friends when the topic of what we all do for a living came up. Afterwards, for some reason, one of the folks in attendance asked me what investment advice I would give them3.
After outlining what I do with my own money (set up regular automated payments into tax efficient accounts where the money is invested into simple, low cost investment vehicles), I suggested that the next best thing that they could do would be to lose the password to their investment platform log-in. I was only half joking.
As an individual investor, you have no-one to answer to other than yourself. No boss, no clients. Therefore you are free to adopt whatever approach to investing that you desire.
Why not adopt the one that a) that gives you the highest probability of ensuring victory and b) requires the least effort? Sounds like a pretty good deal to me.
Have a great weekend.
Past performance is not indicative of future returns. None of the above is intended to constitute advice to any specific individual. If in doubt seek out professional advice from a regulated financial adviser.
In the interests of fairness I have deliberately chosen a study which focusses on analysts’ ability to predict future earnings growth, rather than share price movement. This is because an analyst’s role is to model the future operational performance of the business, rather than to take a punt on where the share price is going.
Regardless of this, many equity analysts at investment banks will produce share price “targets” or predictions. In the majority of cases these prove to be less than useless, abandoned at the drop of a hat when the price moves against them.
As Berkshire Hathaway held its annual shareholder meeting on Saturday - it would be remiss not to include some words from the main man himself this week.
If anyone from the FCA is reading, I mean “advice” in the least literal sense.
Agreed David. Get your asset allocation right. Populate with low cost funds. And behave yourself! Boring inactivity is good when it comes to long term investment results. Counter intuitive but true!
You had me at Agincourt!