What Is Your Comparative Advantage?

There are many people, who although know a great deal about the stock market, are not able to “beat” it. The stock market is largely a losers’ game. A commonly used metaphor is that it is a casino and many of the retail investors are the walk-in gamblers where the odds are structurally stacked against them once they enter.

And it only gets worse if you don’t understand yourself well. Like what kind of person you are. Someone who is easily greedy or envious of other people, or someone who gets panicky or fearful easily when things look gloomy. If you don’t know who you are, the stock market is an expensive place to find out. And it is not something of a choice — if you want to do well in the markets, you have to first understand yourself well.

Occasionally, stocks may be priced reasonably. But it is not uncommon to have huge mispricings happening to stocks from time to time.

How would you be able to know which stocks deserve your attention and money?

How do you know when is it an appropriate price point to buy?

What kind of differentiated, insight-generating skills do you need to possess that most other market participants do not have?

Is it tested and proven that what you believe in works and is sustainable?

If you do not have the answers to the above questions, you do not have an edge over the other market participants. Which means your odds of doing well dramatically reduces.

Consider the elite market participants that you are facing up against. This is an industry that attracts the intellectual Olympians of every discipline on Earth. People with the sharpest mind. The best mathematicians, statisticians, coders, analysts and so on. Such is the calibre of the people you are up against.

Talk about their limitations

But we do not have to copytrade them. They may also not reveal all their positions. They have their own game plan, their own agenda and own targets to meet. Hedge funds for example are notoriously short-term in perspective. They report results quarterly. They might be incentivised to do well this quarter at the expense of the whole year. If the catalyst for a good stock that is poised to do well is more than three months out, they might probably not be bothered about it.

Mutual funds can rarely beat the benchmarks. A mutual fund, if it’s good, will be managing a lot of money and the more money you have under management, the harder it is to beat the market.

First of all, once a mutual fund gets big enough, every time it buys or sells a stock, it ends up moving the stock because the fund needs to buy an enormous amount of shares to make any difference to its portfolio.

When you buy a ton of stock, such as a few million dollar positions, you dramatically increase the demand for that stock and prices go higher. Conversely, selling an enormous position increases the supply and drives down prices. So mutual funds are anything but nimble. However as a typical professional investor or retail investor, our transaction will not make a splash, especially when we use limit orders and not market order to buy.

The other problem mutual funds have that we individuals do not have is when they really have a successful year, they’ll get a lot of new people flooding them with money. So any fund that’s really good will be hobbled or that they may start coming up with new ETFs or themes in order to deploy the money elsewhere. Sounds pretty familiar? Once a mutual fund gets really enormous, it becomes more and more like an index fund with high fees.

Why we can beat the pros

In terms of results, individual investors do not have to worry about producing short term results on a daily, weekly or quarterly basis to keep our clients happy like the pros have to do. If we have conviction, we can possibly have more holding power as opposed to them who need to deliver much quicker results. We may even decide to concentrate more on positions that offer very attractive risk to reward setups that may payoff only in a few years while having a few quarters of temporary underperformance.

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How we can beat the pros

In order to beat the pros, we need to know how they make money, and why most retail investors lose money. Understand which areas we can have an edge over them.

Then, in the areas that we don’t or can’t have an edge over them, what do we do? There’s always a saying, if you can’t beat them, join them. Learn how to invest alongside the big boys and sell alongside them as well. Swim with the whales.

1. Analytical advantage

By actively managing our own money, we can beat the market with a handful of stocks we pick by taking risk-minimal entries and exits. This is the analytical advantage which comes from having the same information as everyone else, but using it differently by performing fundamental or technical analysis. For example, when it comes to technical analysis, everyone is looking at the same charts and so called doing “technical analysis” in their own sort of way but it leads to different conclusions. At the end of the day, it is about whose analysis makes more money most of the time.

With good analysis, you can perhaps reduce the number of stocks you consider while increasing the quality of each idea. If you know what you are looking for, likely you should not end up with too many ideas. Which is why we don’t really have to own more than 20 stocks at any point in time to be able to beat the market.

Knowing what not to look at is just as important. Not every battle is worth fighting, especially in those where you can’t find your edge. I prefer to cast my line in ponds where the likelihood of catching fishes are there.

There are some market participants who focus purely on fundamentals. Some who rely only on technicals. And those who rely on friends. All of them may earn some money at some point in time. The important thing is to be able to find our own source of comparative advantage that is eventually lasting and sustainable that allows you to produce better than average returns over time. Set yourself up in a situation where you are more likely to catch a fish with minimum effort, meaning risk of losing your bait or spending too much time.

2. Psychological advantage

Having the right mental node gives us the psychological advantage in investing. Learn to look past the falling stock prices, the paper losses and the crisis. We know good undervalued stocks will outperform eventually. Do not get stuck on the bad headlines.

The problem comes when many retail investors are psychologically manipulated by price swings. The fear, doubt and uncertainty perpetuated by the mainstream media result in most of them panic selling and capitulating. This panic selling gets escalated when retail investors use the money they need in the short term (such as for their course fees, wedding or renovation) to invest.

Human beings struggle with uncertainty and hate problems that require us to guess at odds and choose between unknown future outcomes. This is true even for the best investors and cognitive behavior experts.

Nonetheless, most of the investing decisions should be made based on our deduction on the most probable outcomes using the best available information. For example, if you had waited until the US vaccination rollout in December 2020 before feeling at ease to start investing in the US stocks, you would have been late to the party. Many of the US stocks have already recovered and even rallied to all-time highs by then. Investors need to be able to make the most educated guesses given the information they have and put aside their aversion towards uncertainties.

3. Explore other strategies

Other advantages may also stem from the risk management methods or options strategies which are devised to maximize returns and minimize drawdowns. These are what we can do to help ourselves to be better than other market participants.

Along the way you could make mistakes. In fact everyone will. No investors can have a clean sheet of zero losses and mistakes can be expensive at times. It can also take vast amounts of time and practice to do it right, and to finetune it.

But such is the same for other endeavors in life that we pursue, just like any other professions be it pianists, sportsmen or surgeons.

Mainstream media have made it seem so effortless to pursue your retirement at just the click of the mouse. They sell dreams. If you get started to invest with those intentions, it is unlikely that you will do well.

Just like a businessman who starts a business just because he wants to be rich would likely not succeed. A business becomes profitable because it value-adds to its customers, not because it wants to be profitable. You get the idea? An investor does well because he is committed to learn his craft and value-adds to himself with good analysis and methodology.

When you want to do well, you need to put in the hours and hard work. You can choose to try to figure it out yourself, or learn from a mentor who has been there and done that, to shorten your learning curve. Either way, you must find your comparative advantage. You must have already shifted the probabilities in your favor before you even begin. Otherwise you are basically entering the battlefield unarmed, and perhaps it could have been better if you didn’t even get started in that case.