How To Gain An Edge in The Market
I am a sophomore at an undergraduate business school majoring in finance. I am past the core finance class and onto corporate finance, and after learning more in-depth about the CAPM, Efficient Market Hypothesis, and asset valuation theory in general I have come out more confused than before. I am not now confused because I do not understand what these theories are trying to teach us, but what I do not understand is what they aren't telling us. What's the trick? After only recently learning the theoretical part I am already tired of it and would like to learn some kind of applicable or real life finance, but that doesn't seem to be a part of the curriculum.
My question is for all of those in the market who clearly do have an edge, hedge fund managers, traders, asset managers, or anyone who invests in anything: How does one gain an edge in the market?
We are taught that it is statistically impossible to gain any kind of edge in the market and we might as well buy an index fund or flip a coin, but that clearly isn't true for everyone.
Thanks
An edge can come in many forms. Some edges are speed-based, execute arbitrage opportunities faster than everyone else looking for them and you have an edge. Sell options where you're collecting theta value; that's an edge. Or trade spreads with statistical advantages. Develop an indicator that no one else is looking at. The list goes on.
One of my favorite examples to bring up to people talking about efficient market hypothesis is James Simons and Renaissance Technologies. They've averaged 35% return after fees since 1989. Nobody beats the market like that for 25 years straight by getting lucky.
Academia loves the EMH because it enables them to do "research". If they aren't able to assume that markets are efficient than it becomes really difficult to run any sort of tests on various risk premia etc. In reality, markets that are deep and liquid are quite efficient, but that doesn't mean that there aren't individuals who can beat them. It means that all of the information available TODAY is being rapidly translated into prices. But if an investor has an ability to anticipate what kinds of new information are likely to present themselves in the future, they can certainly gain an edge on the market. Obviously there are clean ways and dubious ways to do this, but I think history has given us a number of tremendous investors who prove that alpha does exist. Jim Simmons (noted above) is one, along with Buffett, Jeff Gundlach (my current favorite), Peter Lynch (back in the day), Ken Griffin, and lots of nameless people at places like Capital and BlackRock.
Unfortunately, no professor is going to be able to teach you how to get this "edge". Let's face it, if they could they probably wouldn't be teaching. Good profs can however give you the toolkit you need to make those kinds of discoveries on your own, so stay awake!
Have your father be a union representative for a publicly traded airline...
Consider those things the "basics" of finance. After you have that foundation, you can now start putting in your ideas and theories. Lets say you apply this toolkit and you come up with a share price. Your valuation is different from the market price. You then ask why. Is the market right and I'm wrong? Maybe the stock is overpriced ect. The market is not perfectly efficient so someone can still get an edge. The most obvious way is to have information that others don't.
I agree those theories are an absolute waste of time. If you want to get good at analysing balance sheets, learn accounting.
this may not be the the answer you're looking for, but i used to think about the same question when i was a soph. what i've realized is that i had been asking the wrong question all along - instead of focusing on how to gain an edge in the market the focus should shift to recognizing and leveraging your own edge. for macro, this may be being able to find unorthodox divergent trades, aggressive short term trading, risk management skills etc. as for emh, the presence of various forms of systematic 'risk-premia' that have historically generated excess returns - things like fx carry, commodity momentum, small-cap equity value etc - largely disputes all forms of emh. those things shouldn't exist in perfectly efficient markets, yet they do...
there are tons of academic studies on how to invest. Go read them at the SSRN.
If you want to gain an edge in the market you will want to drop pretty much everything in academia and start reading 10-Ks, 10-q's, proxy filings, and contacting management, etc. If you're wanting to pursue a long/short investment career.
At the hedge fund I summered at last year, I would set up conference calls with various management teams to learn more about their businesses, and I would build financial models incorporating drivers of sales and expenses that I learned about in the conference calls.
One of my better performing investments this year is a company that is hard to find information on. I wound up calling the largest shareholder, and hence, I gained an edge in learning about the history of his investment, his actions in firing the incompetent CEO, and some color on the future prospects of the company.
It's a ton of fun and the hunt is worth it!
Depends on which you're most suited for. Institutional funding also helps. Ultimately there are two general types of fundamentals, the one that pushes the market from point A to point B and the other type which deals with how we get there (how supply/demand enters the market).
Hey Archer, Could you elaborate a little on these two fundamentals? I'm just a little confused. What are these fundamentals in regards to exactly? Could you just elaborate on what these fundamentals are, and how they can be viewed in regards to this thread, how can we find an edge in those fundamentals?
Thanks
I expounded on the former in a recent post that you also commented on by OddballStocks. The latter is another discussion.
Generally, you can't unless you insider trade.
In my opinion the way to beat the market is to manage your asset allocation across indexes and asset classes and keep a very close eye on the macro picture. Knowing where we are in the productivity curve, short term debt cycle and long term debt cycle is critical. Also check out the theory of reflexivity.
If you were able to detect the .com bubble and housing bubble of 08 and hedged or pulled money out of the market you would have lost far far less and been able to invest at rock bottom prices. You'd also have absolutely destroyed the market return.
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