In the stock market, there are atleast two parties to every trade – a buyer and a seller.
This buy-sell relationship is not like it is in your everyday transactions like buying shoes for example.
When you buy shoes whether from a store or a website, the person who is selling it to you is a supplier or even a manufacturer.
They exist to sell you stuff.
In the stock market, there is no such thing as a “supplier of shares” who can keep producing more shares to sell to you.
The seller, here, is normally a person with a different world-view on the underlying asset.
You think it is worth buying the shares at a price while he or she thinks it is worth selling at that exact same price.
That is some serious disagreement!
In a lot of cases the person on the other side is an institutional investor, trader or some big fish.
In that moment when you do the trade, the 2 of you have exactly opposite opinions.
Who is right and who is wrong?
Why do you think you will make money from that investment?
Do you have some kind of edge that gives you this confidence? Or are you just shooting in the dark?
In the world of investing there are 3 kinds of edges:
- Information edge
- Analytical edge and
- Behavioural edge
Let us take them one at a time.
Information edge would mean you have access to information others don’t have or you get the information before everyone else does.
The way to profit from this edge is timing.
You need to act on the information before everyone else finds out, even if the advantage you have is just a few minutes or seconds.
Getting the information edge to consistently work in your favour is a function of faster systems, relationships and resources.
There is no legal way that an individual investor can even begin to compete in this game, let alone win it against the large institutions.
Next is the Analytical Edge. How do you think about and process the information that is out there, available to everybody?
Your biggest obstacle with the Analytical Edge is the competition.
The world of investing is filled with really smart people who love their work, put in crazy hours, are supported by all kinds of fancy technology and tools of the trade, and have very high incentives at stake to get things right.
You are an individual investor spending a few hours every month to manage your investments.
You can work on improving your analytical skills over time, but getting the analytical edge over full-time participants in the market will most likely be an uphill task.
So far, the institutions have both the edges. You are down 2-0.
Time for the final edge: the Behavioural Edge.
Institutions are made up of individuals. The market therefore is, directly or indirectly, made up of individuals.
As the market goes through its ups and downs, every market participant is vulnerable to his or her emotions of greed, panic and also boredom, when greed or panic are not in play.
The Behavioural Edge is about not letting your emotions and knee-jerk reactions drive your investment decisions.
Don’t get depressed with the crowd as they lose hope believing the doomsday scenarios.
And don’t get euphoric with the crowd as they get intoxicated by their own optimism and do stupid things.
The Behavioural Edge is in not buying or selling just because everyone else is doing it or talking about it – whether at work, in your social life or all those “experts” in the media.
Stick to your plan. Don’t get carried away. Exercise restraint.
It is almost like being a teenager again; not giving in to peer pressure; learning to say no.
Managing your emotions is a very personal thing.
Which is why, the Behavioural Edge is where the individual investor can outclass everyone else.
Most institutions really suck at bringing the Behavioural Edge to bear on their work; the bigger they are, the worse off they tend to be.
There are just too many teams within an institution who could be working with competing objectives.
Not to mention the sword of career risk perpetually hanging over the heads of decision-makers.
It is extremely difficult to exercise the courage to stand alone against the crowd when so much is at stake – profits, jobs, reputation.
And sometimes it is just not in their hands…even when they can see that they need to behave differently, they are forced to toe the line and become part of the quintessential but tragic corporate adage: it is better to fail together than succeed alone.
The Behavioural Edge can be all yours. The final score is 2-1.
Going by the numbers, it might seem like the individual investor has lost.
But as with most things in the world of finance, you must read the fine print.
There is more to the 3 Edges than meets the eye.
The unfair advantage of the individual investor is that even with the lower score, you can win.
The Behavioural Edge is more powerful and can be a more sustainable advantage than the other 2 edges.
As for the 2 winning edges of the Institutional Investor, instead of trying to beat them at their own game, hire them to work for you.
Simply invest in carefully selected mutual funds they manage and you will benefit from their 2 Edges as well!
And don’t worry about them getting the Behavioural Edge.
For that, their respective corporate cultures will have to change. And we know how hard changing an institution’s work culture can be!
So don’t get overly worked up about information and analysis.
For investment success, focus on developing your Behavioural Edge.