How To Develop An Edge In Investing

If you ask any successful person what makes them successful in their work, it inevitably boils down to the fact that they have developed an edge over others doing the same thing as them. They could have developed that edge by honing their skills through hours and hours of practice or they could have discovered a secret unknown to others but this is very rarely the case. Usually, it is more likely that they see the same things as others but with a unique perspective. In other words, they can connect the dots. Similarly, professional money managers talk about this thing called Edge.

What Is Edge?

In simple terms, Edge is what allows money managers to pull money out from the markets over the long run. Or to put it in statistical terms, Edge is what skews the odds in your favour to win in the long run. If you make money from the markets but is unable to explain the Edge, then you probably were just lucky. And no, buying low and selling high is not an Edge. The latter guarantees the former over the long run but the former does not necessarily imply the latter. Investing Edge must be based on some fundamental unchanging principle of the markets. Just to give a very simple example, equity markets are bound to go through boom and bust cycles. An Edge can be based on capitalizing on these boom and bust cycles. Another example is that volatility regimes also go through low and high cycles whereby an Edge can also be derived. The above sounds simple enough but the devil is in the details as they say. The difficulty is in crafting a strategy that can allow you to capitalise on these fundamental unchanging principles. But at least these principles provide the basic reason why a particular strategy is expected to have Edge.

Can Edge Disappear?

The short answer is yes in the short run but not in the long run. Edge may disappear in the short run when too many people are trying to capture the same Edge. There are many extensive papers written on this phenomenon but suffice to say that it is due to the overcrowding effect. However, this does not mean that the underlying principle of the market is gone. Markets will still have boom-bust cycles and volatility regime changes. What it just means is that it is no longer profitable to employ strategies that depend on said Edge. What will happen is that the weaker players will start to drop out of the market and when enough players drop out, the overcrowding effect disappears and the Edge will come back. Any serious money manager should realize that they cannot only depend on one Edge to generate consistent returns over time but to have multiple diversified Edges in their portfolio so that when some stop working temporarily, at least others are still working.

How To Develop Edge?

So how does one develop an Edge in the financial markets? Well, the same way that anyone develops any kind of mastery in any other field. By immersing oneself in the activity and learning the right lessons along the way. Learning the right lessons is what differentiates someone from eventually achieving mastery and someone who continues to make the same mistakes over and over again. However, to learn the right lessons, one must have an open mind and must know how to ask the right questions.

Everyone has their own investing journey and the lessons that come with it. I can only share what I’ve learnt in my journey. While I do not claim to have achieved mastery in investing, I can honestly say that I’ve learnt valuable lessons every step of the way. I thought I should write them down here so that I may look back at these lessons even if my memory fails me as time passes.

The Beginning

I started my investing journey in 2001 shortly after I entered the workforce. Like all newbie investors, I did not have any investing plan so I simply opened a brokerage account and started buying stocks. The way I chose stocks to buy is very random. I could have read about a company in a newspaper or broker research and if I thought there’s potential, I would buy. And somehow, I gravitated towards penny stocks because I mistakenly thought that stocks with a low price have more room to increase in price. Needless to say, I soon learnt that it is the percentage change in price that is more important than the absolute price level. You can buy a stock priced at $0.02 but the moment it drops to $0.01, you would have lost 50%. But most people only focus on the potential upside. They would think that the stock only needs to climb 1 cent and they would already make 50%. However, they have merely subjected themselves to huge volatility because their PNL (profit & loss) would swing in large percentage terms. And my experience tells me that most stocks that are trading at that kind of low price tend to stay at that low price or eventually disappear by delisting.

Initiation To Black Swans

Shortly after I started my investing journey, the market was very “kind” to me by shocking me to the existence of black swans. I will always remember this event because it was surreal. I was watching TV when suddenly I saw a passenger plane crashing into one of the twin towers in New York. I was wondering what new Hollywood movie’s trailer am I watching when I noticed that it was a news channel that was showing the image. That’s when I realized that this was happening live and my heart immediately sank. It sank not only because it was a senseless act that harmed innocent people but also because I knew my portfolio which was 100% loaded with stocks would be hit badly. True enough, my portfolio immediately dropped 10% when markets opened the next day and it proceeded to lose more over the next few days. This experience taught me to never discount the possibility of a black swan event even to this day.

Macro Is King

It was a good thing that I did not panic sell and my portfolio gradually recovered. Then 2003 came around and I learnt another big lesson. By this time, I had picked up fundamental analysis and was no longer randomly picking stocks but rather filling my portfolio with stocks that I’ve carefully researched. I looked through financial reports and even built excel spreadsheets to track companies’ key financial ratios. I can say that my portfolio is filled with fundamentally sound companies. However, SARS hit the region hard and Singapore was affected as well. I could only watch my portfolio bleed day after day even though the companies in my portfolio were not directly affected by SARS. What this tells me is that the macro environment is more important than individual stock picks. In fact, research has shown that asset allocation decisions determine more than 80% of your portfolio performance.

The Market Doesn't Care What You Think

Again, I held on and my portfolio eventually recovered and started to grow, in line with the bull market that started after the SARS episode was over. Then in 2005, when I was sitting on some comfortable profits in my portfolio, I made a discretionary call that equity markets were getting a bit expensive and so I proceeded to sell all my stocks and sat in cash. I was thinking that the market was going to correct and then I would go in again. However, the market started a very fierce move to the upside and I was left behind. I was like the proverbial deer caught in a headlight. I was too scared to go back into the market because it was running too fast. It was a good thing that I was pursuing a career change during this time and in the middle of a post-graduate degree so that I can ignore markets for a while. In any case, this experience taught me that markets do not care about my views and I can be too smart for my own good.

Having A Plan Is More Important Than Being Right

2007 soon came around and at that time, I was working for an investment bank covering hedge funds and institutional clients. Due to my privileged position being able to talk to some of the big players in financial markets, I was keenly aware of the sub-prime crisis that was developing in the US. I developed a strong gut feeling that something bad was going to happen to the global financial markets with the US being the ground zero. I proceeded to build up a sizable synthetic short position on the S&P 500 using options towards the end of 2007. Very quickly after I put on the position, the crisis started and I was ecstatic that my timing was accurate.

However, my elation soon turned into stress as my PNL swung wildly as markets went into a volatile stage. I soon realized that even though I had an entry plan, I did not have any game plan for holding my position and I also did not have an exit strategy. Hence, I did not know what the next step was for me. I could only watch my PNL swing from day to day and go along for the roller-coaster ride. Finally, on the day the US government announced the TARP plan in Oct 2008 and the S&P 500 surged 10%, I gave in and closed out my short positions and went slightly long. But the market did not bottom till March 2009.

This experience taught me that you need to have a game plan not only on when to enter but also what to do after entry and when to exit. Even though I made money from the GFC, I recognized that I was just lucky to be in the right place at the right time and that this was a once-off event. I do not know what my next trade is going to be after this. Hence, I was motivated to find a more sustainable approach to investing.

Independent Research Is Important

It was at this point that I recalled my thesis project during my post-graduate degree program. I looked into how a risk management approach to investing in equities can beat a simple buy and hold approach. For my thesis, I developed a model and tested it across global markets including developed and emerging markets. The conclusion was that the model indeed performed better than a simple buy and hold approach not just in terms of giving a higher long term return but also minimizing volatility and drawdowns. I put in more work into the model and what came out of it was a stock trend following model. I quickly implemented the model in the second half of 2009 but Mr Market proceeded to teach me the next lesson.

There Is No Perfect Strategy, Diversification Is Key

Trend following was one of the rare strategies that did well during the 2008 GFC. However, the period from 2010 to 2012 turned into a prolonged winter for trend following. Markets lurched from crisis to crisis. The epicentre of the Great Financial Crisis moved from the US to Europe and Eurozone nations took turns teetering on the edge of bankruptcy. Equity markets went into a range-bound mode making trend following strategies suffer from whipsaws. Initially, I thought this was going to be a temporary situation and the next trend would soon emerge but Mr Market made sure I got the memo.

Embarking On Multi-Strategy Approach

So in 2013, I decided to look into alternative strategies that can complement the trend following strategy. This led me to develop an asset allocation strategy and a volatility trading strategy and I began to introduce these strategies into my portfolio gradually. It was a good thing that I did not give up on trend following because it made more than 40% returns in 2017. By that time I was already running a multi-strategy portfolio so the overall return for that year is lower than 40%. But it is ok because I’ll rather have some profits every year than have lumpy returns and losses in some years.

Looking back on my journey, I'm glad that I have asked the right questions, learnt the right lessons and found an approach that suits what I’m looking for. I have not looked back since.