3/17/14 – Changing the Odds on Investing

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 17, 2014 11:50:50 AM

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I wrote last week about how investing is, or should be, significantly different from gambling. Despite those differences, though, there are many things we as investors can take away from the gambling perspective. One of the most valuable is the concept of edge, which is closely related to the notion of odds.

“Edge” can be defined as how much a gambler, or the house, can expect to make over time. A 1-percent edge, for example, would result in a profit of 1 percent of the amount wagered. Take the game of baccarat, where, on average, the house has an edge of 1 percent per hand, which doesn’t sound like much. Given that baccarat is usually played at the rate of 70–80 hands an hour, however, even a 1-percent edge can mean serious money.

We don’t make 70–80 investments per hour, but we do have periods of years or decades to work with, so a 1-percent edge can be equally important for us as investors. A common way to find an edge is to manage and reduce expenses. Lowering your expenses can be a risk-free way of pursuing higher returns. It may be worth considering, if at all possible. There are also other ways to try and get an edge, such as risk management.

A simple and easy way to potentially manage risk is to rebalance regularly. Why might this be helpful? First, you’re locking in profits by selling some of the winners. Second, you’re buying at cheaper levels by putting more money into the recent losers. You can consider rebalancing a form of market timing, in the sense that you’re selling expensive assets to buy cheap ones—and it can be effective, over time.

Another way to try and get an edge is to find indicators that help you understand what’s coming next. Like rebalancing, it would be easy to confuse this with market timing, but it is different. Market timers believe they can predict the market; they can’t. Investors looking for an edge don’t need to predict the market; they just need to find signals that have worked reliably in the past and that can possibly indicate what might happen.

In other words, if I’m playing poker, and my opponent has three aces showing and is betting very aggressively, I don’t know that he has the fourth ace, but it had better affect the way I bet. Similarly, for investing, if something happens now that has indicated a significant decline in the market eight out of ten times in the past, I probably want to know that when I invest. In a sense, this is pure market efficiency—after all, aren’t you assumed to take all information into account?

Over the next several posts, I’ll talk about different indicators and how and why they might be useful. No one indicator, or even several, is predictive, but they can help you set the odds. As noted above, even a small advantage is worth having over time.

Upcoming Appearances

Tune in to Bloomberg Radio's Bloomberg Businessweek on Friday, February 28, at 3:45 P.M. ET to hear Brad talk about the market. Stream the show live at https://www.bloombergradio.com/, listen through SiriusXM 119, or download Bloomberg's app, Bloomberg Radio+.

Tune into Yahoo Finance's The Final Round on Thursday, March 12, between 2:50 and 4:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Watch at finance.yahoo.com

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