Edge is word that lots of professional investors like to toss around. In any industry, there is jargon adopted to identify insiders and exclude outsiders. This jargon is just calling a simple concept by another name to segregate those “in the know” from outsiders. In reality, edge is quite a simple concept and refers to something that gives you an advantage over other investors. Your edge is what will allow you to have success as an investor.

Edge is also a relevant concept if you have chosen a managed fund that is actively managed to try and exceed the returns of an index. In this case, you are picking a professional that you believe has an edge over other investors.

There are three primary things that give investors an edge – informational advantages, analytical advantages and behavioural advantages. We will go through each of these in detail below:

Informational advantages

An informational advantage refers to having information about an investment that is not widely known. For the purposes of this discussion we will exclude insider information although this certainly constitutes an advantage, albeit an illegal one. Legal informational advantages used to be quite common when the investing community was more of a closed club. This has partially been changed by enacting more securities regulations, partially through the work of individual investor advocates such as Morningstar and partially addressed through the internet and the democratisation of information. To gain an information edge today requires investors to go to great lengths. There are many stories of Hedge Funds hiring satellites to count the cars in retailer’s parking lots and digging deep into the supply chain of manufacturers to try and anticipate future sales results. Except in rare situations the informational edge is not something that most retail investors can use to their advantage. The significant increase in transparency has been a huge positive for the wider investor community but it also means that there are few legal informational advantages that can be exploited.

Analytical advantages

Analytical edge refers to the ability to interpret widely available information in a better way. An analytical edge can manifest itself in many ways and can consist of a quantitative model that is better able to look at key security or economic metrics or simply an individual that has deep knowledge of an industry and can better predict the impact of a company’s strategy, a legal or regulatory change or a business trend. At Morningstar, we are proponents of analytical edge and have developed a methodology based on three core principles: sustainable competitive advantage, valuation and margin of safety.

Behavioural advantages

Behavioural edge is perhaps the most interesting and least understood investor advantage. It is grounded in the fact that humans are genetically hard wired to make poor investing decisions. We are driven by fear and greed which is formula for buying at the top of the market and selling at the bottom. Both individual and professional investors create elaborate models and theories designed to dictate when and why to buy or sell a security. Despite these models there is still a high probability that an investor will panic when the market is going down and fear missing out on riches when it keeps climbing. The Morningstar fair value estimate is designed to prevent these types of behavioural mistakes. Changes in security prices do not impact the fair value estimate but do change the Morningstar Analyst Rating which is inversely impacted by the price movement. In order to gain behavioural edge it is necessary to internalise the notion that investing is more than a mathematical analysis of risk and return. Successful investing requires a struggle with ourselves to tune out irrelevant information, to have the strength to stick to the plan and resist the urge to follow the herd. Behaviour and patience may be the last real sources of sustainable edge for an individual investor. The ability to endure short term discomfort and focus on long time horizons is an enduring advantage that individuals have over professional investors.

 

More in this series:

 

Mark Lamonica is a product manager, Individual Investor, Australia.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication