Charley Ellis once described the three ways in which investors can beat the market. He said, “One is physically difficult, one is intellectually difficult, and one is emotionally difficult.”
You can work harder, put in more hours, and outwork everyone else. You can be smarter, see the future differently, and better identify when the market is wrong. You can be better behaved, take a long-term investment approach, and hold on.
Unfortunately, most investors focus on the first two. They try to outwork or outthink everyone while overlooking better behavior. If they only realized that more effort and intelligence still requires better behavior to succeed at investing. Every investor walks the emotionally difficult path.
Bill Miller once shared a similar line of thinking when he expanded on Buffett’s idea of a circle of confidence. If investors are true to their abilities, they should not only focus on areas they understand well but have a competitive advantage over other investors.
In markets, competitive advantages are three: informational, analytical, or behavioral. Informational advantage is when you know something material that someone else doesn’t. It is the easiest to exploit and the hardest to find. The securities regulators make it their business to see to that by mandating public release of all material information, by regulations like FD, and stiff penalties for acting on inside information.
Analytical advantages come from taking publicly available information and processing or weighting it differently from the others. The market appears to be pricing Amazon.com as though its current operating margins in the low single digits are a permanent feature of its business model, as they are of bookseller Barnes & Noble. We think that is wrong and that Amazon’s margins will soon begin a steady climb toward and perhaps into double digits. If our analysis is right, we stand to make an excess return from our holdings in Amazon.com.
Behavioral advantages are the most interesting because they are the most durable. The field of behavioral finance is still in its infancy yet has already yielded results that can be incorporated profitably into a sound investment process. The best part is that such results are likely to be systematically exploitable and not able to be arbitraged away as they become more widely known. That is because they represent broad findings about how large groups of people are likely to behave under well-defined circumstances. Until large numbers of people are able to alter their psychology (don’t hold your breath), there is money to be made from prospect theory, support theory, cognitive psychology, and neuroscience.
Much like Ellis’s three paths to superior performance, Miller’s three advantages are difficult to attain.
The analytical advantage fits with Ellis’s intellectually difficult approach. Smarter people, able to see what the market is missing, are at an advantage. But it requires superior knowledge and perspective. It also requires the guts to bet against the market and look wrong for a while, before being proved right.
There are only two ways to beat others at the information game and only one of those is legal. It’s about getting the orders in first. You have to be faster than the fastest hedge funds to make money consistently. Insider information is the other way but it’s extremely limiting and comes with potential legal issues. So the informational advantage eliminates most investors.
That leaves a behavioral advantage. We’ve been hardwired over the millennia to react in certain ways to enhance our survival but that makes us perfectly unsuited for investing. Those natural biases — loss aversion, recency effect, hindsight bias, etc. — influence our decisions, which hurts our performance while influencing asset prices.
Now, not everyone is affected in the same way. Some people are less susceptible to those tendencies. Which allows them to exploit the opportunities those biases create.
The irony is that one of those biases is overconfidence which pushes us to think that we’re the exception to the rule. And knowing that these biases exist doesn’t make us immune in the slightest. But it’s not impossible.
The behavioral advantage exists for everyone willing to take Ellis’s emotionally difficult path:
Being incapable of doing the intellectually difficult, and reluctant about the physically difficult, I have set about the emotionally difficult approach to investing. This straightforward, untiring approach is simply to work out the long-term investment policy that’s truly right for you and your particular circumstances and is realistic given the history of the capital markets, commit to it and — here is the emotionally difficult part — hold on.
Long-term investing is fraught with short-term turmoil. Investors that can hold on through the rough patches naturally achieve a behavioral advantage over others. A systematic investment process combined with patience and discipline is key to superior results.
Legg Mason Fund Commentary 3Q 2006
Investment Policy and the Competent Stranger