Develop your investing edge to become a better investor

The hedge fund community talks about the concept of “edge” all the time. In order to earn their exorbitant 2 percent/20 percent fees, such hedge fund managers need some type of edge over the average investor or else why would anybody bother to invest with them and pay such fees?

Yet for all the hoopla over how great and prestigious the hedge fund industry is, the reality is that their returns have been pathetic over the past several years. For instance, the average hedge fund was up just 5 percent in 2013 vs. the S&P 500's 30 percent! Hedging is not a great strategy in a bull market. Neither is being too smart for your own good. You can actually track or buy a hedge fund index through the ETF, HDG.

I'm a firm believer that all of us who are not professional money managers should simply buy low-cost index funds or ETFs. The most important thing we can do is manage our investment portfolio exposure to correspond with our tolerance for risk. It's extremely difficult to consistently outperform the markets, and it's much better to spend our time working on our careers, our businesses, or other areas of expertise to build wealth.

If you want to chase unicorns

Despite my recommendation for developing a consistent savings and index investing system to build wealth over time, e.g. invest 70 percent of savings in the S&P 500 and the other 30 percent in municipal bonds, I do think it's worth it for people to take more risk, especially when young. If you blow yourself up as a 26-year-old, at least you've learned a lesson and have more time to recover your losses. It's also very hard to take risks once we have a family that depends on us.

One of my biggest regrets now is not investing more money during the Internet bubble of 1999. I hit one huge home run in 2000 at the age of 23 and basically stopped looking for unicorns for the next five years because I was afraid of losing money after the bubble burst. But money-making opportunities present themselves every single day, long or short. We just have to spend time looking!

If you want to chase unicorns, then I propose you set aside no more than 10 percent of your net worth to actively manage. For example, I designated my rollover IRA when I left my job in 2012 as my Unicorn Fund. For those who feel they have investing super powers and find no need to limit their net-worth exposure in active investing, then the following advice on developing an edge should be considered even more important.

Developing your edge

“Edge” is just a code word for investing in what you know very, very well. My edge is investing in Asian equities because I grew up in various Asian countries, worked in Asian equities for 13 years, and speak a couple Asian languages. There are subtle cultural nuances that are exploitable if you have the experience in reading the tea leaves. For example, I wrote a 2,000-word article in May, 2012 explaining why I think Chinese equities, especially Chinese Internet stocks were poised to begin outperforming. As someone who runs an online business based in San Francisco and actively participates in social media as well, I thought this combination gave me a knowledge advantage. Names such as Baidu and Sina are up 100 percent and 55 percent since, respectively.

If you were to ask me about investing in apparel companies such as Lululemon or Under Armour, I would have no clue because I don't have any industry experience. All I can tell about Lululemon is what everybody else knows: estimated earnings growth for this year, operating margins, their CEO debacle, and basic balance sheet information. I have no edge, which means I have no way to exploit the stock.

The fact of the matter is, everybody has some sort of edge they can harness when investing. If you go to the casinos to play blackjack, even a 1 percent edge over the house can result in massive profits if you have a large enough bank roll to sustain the ups and downs. No wonder card-counting is frowned upon.

Discover your edge

  • Industry experience. Everybody works in some industry. The longer you work at an industry, the more you will understand the industry given you've been through the cycles and understand the various competitive practices. Many money management firms hire industry veterans to become industry specialists. One common example is hedge funds hiring medical doctors to co-run health care funds. When you've spent 15 to 20 years after college specializing in oncology, you are the expert in cancer treatment, drugs, and equipment.
  • Cultural background. You don't have to invest money only in your country of residence or origin anymore. There are ETFs that allow you to invest in emerging markets such as Europe, Africa, and the Far East. Let's say you lived in Greece for 15 years before coming to the States for the last 15 years. You understand Greek culture more than some Emerging European analyst who only goes to visit companies in Athens once a year. During the Greek debt crisis, maybe you would have found an edge in the political rhetoric which would have given you the courage to buy Greek bonds at 10 cents on the dollar enabling you to make a killing just a couple years later.
  • Areas of interest. Perhaps you're really not interested in your industry or you've never immersed yourself in another culture other than your own. The next logical place to look for your edge is in intense areas of interest. Perhaps in 2005 you were a college football and NFL fanatic. You went to every single game within a four-hour driving radius and you noticed Under Armour uniforms popping up everywhere. You thought to ask the players what they liked about Under Armour products early on, and they raved about the material, style, and fit. (Under Armour stock is up 800 percent since going public in 2006, and went up 60 percent in 2013.) You get the picture.

What's your competitive advantage?

Gaining a 2 percent edge puts casinos out of business over the long run. Most people don't consider active investing gambling because research can be done to improve one's chances of making money. Where people mess things up all the time and lose or underperform is when emotions and misinformation gets in the way.

Active investing is a losing proposition over the long run, as study after study has shown. That doesn't mean there aren't active investors out there who are crushing it. Investors such as Warren Buffett, Ray Dalio, Peter Lynch, George Soros, Carl Icahn and many more are making outsized returns because they've developed some type of edge in their investment process. They don't invest in everything under the sun because their edge doesn't scale without hiring good people with their own edge.

If you are going to spend time actively investing a portion of your net worth, then it's important to go in with the understanding that you can and will lose money. Hopefully you've focused your investments on areas where you think you have an edge to outperform. Otherwise, it's much better to spend time on your expertise, investing index funds, or let a professional money manager try and make money for you.

Readers, where is your edge when it comes to active investing? Do you actively invest your money? If so, how have you done over time? What percentage of your net worth or investment portfolio do you carve out to actively invest?

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Nick
Nick
6 years ago

I’m also a firm believer of index funds and consequently avoid paying high fees for hedge funds. Recently I’ve started to invest in Dividend Aristocrats so I waiting to see how that goes. Great article, thanks for sharing.

Malcom
Malcom
6 years ago
Reply to  Nick

Nick,

I also recently started investing in Dividend Aristocrats. A great website for conservative dividend investing is wwww.theconservativedividendinvestor.com

Nick
Nick
6 years ago
Reply to  Malcom

thanks Malcolm, I’ll be sure to check the site out.

Snarkfinance
Snarkfinance
6 years ago

This is solid advice and is what anyone would hear from famous, successful investors such as Peter Lynch. It is best to start investing by sticking to industries and products that you know because you have a built in “edge”. Right on, Sam.

Brian
Brian
6 years ago

Love this article. Thanks for sharing.

Rich
Rich
6 years ago

This is all very well, but the bit about Buffett, Lynch, Icahn, etc. is very misleading. Those people got rich due to leverage, something that is hard to come by nowadays.

Financial Samurai
Financial Samurai
6 years ago
Reply to  Rich

You sure leverage is hard to come by? You can open up a margin account on any one of the online brokerage accounts, or buy double or triple levered ETFs if you want to.

Kristin Wong
Kristin Wong
6 years ago

Hey Sam! I just started active investing over the past three months, and I think I’ve done ok so far–the return is about half of the principle amount. It scares me, so I tend to pull out after a certain amount of profit and then move on to the next thing. Sometimes, that’s worked in my favor; other times, I end up kicking myself. In an effort to learn more about active investing, I’ve been educating myself on the basics, watching/researching certain companies, and then buying/selling accordingly, noting my lessons along the way. It’s a small amount I’m working with… Read more »

Financial Samurai
Financial Samurai
6 years ago
Reply to  Kristin Wong

A 50% return in 3 months is huge, especially if annualized!

It’s going to be the big debate about fear and greed the more active you get. Just don’t confuse “edge” with common knowledge.

For example, I have several younger friends who love Netflix and ended up buying the stock at $380 b/c they felt they knew this is what everybody their age spends their time on nowadays. It’s probably true, but the stock is down $20 today alone after an MS downgrade on margins and competition.

Best of luck investing for 2014!

K-anon
K-anon
6 years ago

In addition to identifying and using one’s ‘investing edge’, a lot can be said for contrarian investing. Being a true contrarian with some percentage of your actively managed funds can pay off. Ignoring the hype and looking for value is how Buffet made big money and I’m hoping to do much of the same.

Financial Samurai
Financial Samurai
6 years ago
Reply to  K-anon

I agree. I love contrarian investing, but in a bull market, it doesn’t work as well b/c everything is going up. Easier to be a momentum investor.

But I am looking at REM now, as the space is hammered and it has a 16% yield.

Accident Claims
Accident Claims
6 years ago

Anybody who has studied investing has heard of the random walk hypothesis and the efficient market hypothesis. Both support the idea that you cannot beat the market, that most mutual funds fail to beat the market, that those who do beat it through luck or taking on more risk, and that monkeys throwing darts at the Wall Street Journal can pick better portfolios than most professionals. Then, you scour the internet and it is full of back-tested results from “gurus” like Peter Lynch, Joseph Piotroski, Ben Graham, Joel Greenblatt, etc. that beat the market. Validea.com and AAII.com are two examples… Read more »

Paul in cAshburn
Paul in cAshburn
6 years ago

The best investment strategy to follow with 90% of your savings is: “I don’t know, and I don’t care.” This means that you diversify by buying the entire market through low expense ration ETFs. VTI, VEU, TIP. Done. Then with your other 10%, pursue your (probably hare-brained) schemes to beat the market – buying stocks in things you “know”. (Ask Enron and WorldCom stockholders whether they “knew” their investments.) Even if your 10% goes south, you’ll have the other 90% in low-cost investments that enable you to say about the market: I don’t know what it’s going to do, and… Read more »

MoneyAhoy
MoneyAhoy
6 years ago

I like investing in things that I know and use all the time. I think your advice is spot on.

70% Market index funds.
20% bonds.
10% unicorns based on your intimate knowledge of some sector of the economy. If you don’t have any special knowledge, then just roll this into MIFs.

Cruncher
Cruncher
6 years ago

I think you are definitely right about investing most of your money in “low-effort” investments (although the exact proportions and assets should vary depending on the investors needs and stage of life I think). I like the idea of “unicorns” – looking for edge yourself. I’m not a big fan of paying for active management, but doing it yourself with money you can afford to lose, in an area you have an edge is a winner. I don’t have time to do that myself at the moment, but I think small caps in an industry you understand is a great… Read more »

Financial Samurai
Financial Samurai
6 years ago
Reply to  Cruncher

It’s that unknown, uncovered small cap stock in VCSY that went from $3 to $160 in three months that did it for me in 2000. If only I had invested more money in the name!

Kasia
Kasia
6 years ago

I think the most important thing is to understand what you’re investing in. I wouldn’t feel comfortable putting my money into a company who’s business activities I knew nothing or little about. And today, with info so accessible on the internet it’s easy to find out companies business operations, their profits and assets vs liabilities.
I like to invest directly in the share market rather than managed funds. I find a few decent companies to put my money into and invest for the long term with dividend reinvestments.

Alan | Networking Secrets
Alan | Networking Secrets
6 years ago

Hi Sam,

this is a very interesting article and you got me with the word ‘Edge’ which happens to be one of my favorite words and concepts.

However what you start off calling ‘edge’ I call ‘due diligence’ – i.e. we shouldn’t be investing in anything we don’t know very, very well – period.

Edge for me refers specifically to a competitive advantage rather than just knowing a market very very well – whether created or from a privileged position you happen to be in.

As an investor, I always exercise due diligence, but I don’t always need an edge.

Financial Samurai
Financial Samurai
6 years ago

Edge should be considered ON TOP OF due diligence, b/c everybody should put in the due diligence before investing in something.

Alan
Alan
6 years ago

Exactly.

just as I said. I was referring to your first sentence: “Edge” is just a code word for investing in what you know very, very well.” when I said this is what I’d call due diligence.

granted, after you elaborated a little more.

In any case, I agree. Any investor should know their market & all conditions very, very well (due diligence).

Edge is about finding further competitive advantage on top of that (if possible).

Elissa @ 20s Finances
Elissa @ 20s Finances
6 years ago

I agree with all of this advice! Especially focusing/finding your “edge” – it’s very helpful to go in with background knowledge and it’s imperative to maintain interest in what you’re investing in. Great tips.

sunny
sunny
6 years ago

this seems entirely antithetical to the idea of “getting rich slowly”

Financial Samurai
Financial Samurai
6 years ago
Reply to  sunny

Sometimes you got to think outside the cage to make money.

Untemplater
Untemplater
6 years ago

If I was mega rich I don’t think I’d put my money in hedge funds. Way too many if them underperform and the fees, ouch. A few do quite well but that’s too much volatility for my stomach. I recently put some money to work in ETFs and I feel good about it. I don’t have a Unicorn fund though right now. In any case, one of the hardest things about investing is not getting emotional. There are gonna be down days in the short term and as aggravating as that is, we have to try and take a step… Read more »

Creatively paid
Creatively paid
6 years ago

Peter lynch would agree with you. One up on wallstreet.

Jason
Jason
6 years ago

I’ve been investing since the mid-90s and hold a degree in Finance, so this is an area I have pretty good knowledge about. This article is pretty good until the last section, “What’s your competitive advantage?” That part doesn’t make any sense, especially considering the earlier excellent advice reinforcing the value of low cost index funds. The notion that investing differs from gambling merely because one can research investments to gain an edge is entirely misleading. The difference between the two is a matter of whether the total “pie” changes in size. In a gamble, the pie does not grow… Read more »

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