How do we differentiate from others in a world where access to information is no longer an advantage?
I work in the financial markets where information has always been the key to success. Yet, in the modern age, with the democratization of information, is it still the competitive advantage? Or maybe we have reached a point where too much information harms our decisions? If that is the case what is the best strategy for those who operate in such industries?
Let’s first think of what determines success in the financial markets (or any other industry dependent on access to information):
- You need the right information.
- You have to process that information in a way that will make money, ie. you need to properly assess how the majority of market participants will act on that information (what can be different to the “correct” interpretation).
- You need the right skills to transform that information into an actionable idea and implement it.
- Luck — there is no certainty in the markets and in life generally— even if you ticked all the above points you can still achieve a negative outcome.
Now, given the above factors, I can think of two competitive advantages over the competitors:
- Information — you might have more information, you might get the information quicker, you might be better at processing and acting on the information.
- Skills — you might have superior skills at doing your job (by skills I mean all kinds of technical skills as well as processes and behaviors).
Its pretty obvious you might win when you are better skilled at your job but can you win by having more (better) information?
In today’s world, it’s getting more and more difficult to win by having greater access to information. Almost everything is widely available, especially in financial markets (even if you have some information which is not public you are not allowed to take advantage of if — it is called insider trading and is illegal). There are thousands of analysts looking at the same set of data and trying to interpret them. How can you possibly claim that your assessment is better than thousands of other smart people? Can you find something that others missed?
I have access to most of the mainstream research providers in my area and what I observe is that they usually have very similar outlooks and recommendations. It is very rare to find strong conviction contrarian view among the leading analysts.
Therefore, the question I’ve been asking myself lately is:
If I am reading the same research and the same recommendations as hundreds of other decision-makers, how am I expected to generate (different) better results? How can I avoid falling into “consensus trap” by doing what everybody else is doing?
What complicates things even more is the uncertain nature of financial markets. You can have as much information as you want but the final outcome of your decision will always depend to a large extent on random variables which you cannot control. What is worse, at some point more information means only more noise. There is a level of information which is optimal and beyond that, you don’t necessarily improve your decision outcomes (I strongly recommend work from Paul Slovic on horse races betting which you can find here for example).
Of course, there will be investors claiming they have exceptional knowledge and skills and they can predict the “unknown”. Very often that leads to a false sense of certainty and an inability to recognize being wrong. Failing to assess how much of the decision was reliant on randomness creates risk for future decisions, the most important being overconfidence.
It’s all invented!
There is also another problem we need to acknowledge before we move on. The prices in financial markets rarely reflect the real value of the asset. I would even go a step further and say — for many assets there is no such thing as the “real value”. We can come up with great models and projections of future incomes to reach some estimate of fair or economic value. The price of any financial assets as well as the bread in your grocery — is only validated when other people are willing to pay as much for it. We can say that some asset trades below or above some “fair value” but we need to be aware that its always theoretical (invented) value.
Ok, by now we recognized the problem. So what are potential strategies to win in this market?
If its all invented make your own story.
This is the dream of any investor. Find the next Apple. Be like George Soros or Warren Buffet. Predict the next financial crisis when no one believes in it…
I will probably disappoint those waiting for a ready recipe but there are no shortcuts or magical tricks here. One thing, however, is pretty clear to me. You will never come up with any original story (ie. trade idea) if you are following recommendations of others (especially if there are many of them suggesting the same thing).
Invest your time in deep independent research. Look out for views which are out of consensus. Who are the people worth listening to in your area? You do not need to agree with them but as long as they have something interesting to say it can help you build your own view.
If you are doing the same things what everybody else is doing you cannot expect different results.
Be an early adopter.
If you know markets usually follow the same story and follow patterns try to get in there before the others. Think of it as an early adopters stage of a product which Simon Sinek talks about in his famous TED talk on WHY. If you get in the early stage you increase your chances of generating above-average returns.
Accept the discomfort.
Investment success requires sticking with position made uncomfortable by their variance with popular opinion. — Howard Marks
Be prepared that the original idea will get a lot of scepticism. There won’t be too many sources to serve as a confirmation. Price action will also not be your friend. Yet, there is no other way to be ahead of others.
The other thing that needs to be accepted is the inevitability of making mistakes. There are no miracles — nobody knows the future and nobody will have a 100% hit ratio in their decisions. All we trying to do is to increase our bets but there will be failures on the way.
Look out for “consensus traps”.
If everybody agrees with the idea it probably means its longevity is coming to an end. Avoid falling into that trap but at the same time look out for them — this can be a great opportunity. If the whole market has a similar position what are the circumstances when the market can turn around? Look out for any signs when the underlying regime is shifting and the “crowd” is changing direction.
Find your niche.
It is definitely much harder to beat the competition in areas already widely covered by others. If there are thousand people looking at one thing its hard to imagine they miss something or the price of an asset is not reflecting available information. But if you could find an area which is rarely look at? Or you specialize in one specific field where you might develop a competitive edge over others?
Cut down the noise.
If you can’t find the niche try to be better at processing the available information. There are lots of commentators in the market, experts or journalists who try to justify every single movement in the market. Switch them off. And cut down on the widely popular research. You need to be aware what the market consensus is but you do not need to follow it and spend too much time on it.
Decide on what set of information or signs you need to make a decision. As Daniel Kahneman proved in his studies — there is a limit to how much more information can actually improve the probability of a positive outcome. Very often we try to process too much and instead of improving our bets we just inefficiently using the resources (eg. time).
I find the 80/20 rule (Pareto Principle) very useful. We most often need only 20% of the available information to make 80% of our decisions.
Constantly improve your processing (decision making) skills
This is something which builds on the second competitive advantage which I listed before. If you cannot win with your competition by access to information, try to be better at processing the information. This is a broad topic which I would love to explore in another post but the real advantage these days is not in access to information but by acting efficiently on the available data.
Don’t try to be different at every cost and know when to admit you were wrong.
Having an independent view is great but you also need to know when is the right time to implement it and when to admit a mistake.
“the market can stay irrational for longer than you can stay solvent”
Keep that in mind and manage your risk accordingly to your portfolio risk tolerance and clients appetite. It is great that you are trying to find the next long term winning story but make sure your client (your portfolio) can accept that risk. Decide how much of your portfolio can be allocated to out of consensus strategies. And challenge your ideas constantly. Has any parameters or external settings changed so that your view is no longer valid? Only fools can not accept mistakes, especially when the outcomes depend to some extent on randomness.
The list above is neither conclusive nor finalized. What works for me might not work for others. And at the same time, even my list is an ever-evolving work in progress. The day I will say I know all the answers and success recipes I would probably need to quit my job. Not because I will be so good at that time. More because my judgments will be so dangerous to my portfolio and the people around me.