Billy Boyle Blog

I’ve always been fascinated by how professional gamblers approach decision making under uncertainty and how these methods can be applied in business. I’m reading a great book at the moment called Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone.

I had already been thinking about the Kelly Criterion in the context of project portfolio selection to help determine what fraction of investment should be committed to risky projects.

It also got me thinking about investing more generally and different ways to think about ‘edge’. We can have an informational or analytical edge, but for publicly traded companies and very efficient markets how likely are you going to gain an edge in analysis compared to the pros (Alpha and the paradox of skill).

The two conclusions you could take from this are 1) stick with a purely passive index strategy rather than trying to pick stocks / active funds or 2) to try and find very small or illiquid markets where few people are looking, where you have domain expertise and your efforts in gathering and analysis of information gives you an edge.

I think for normal people their behavior is one area where they can gain an ‘edge’ in investing. One of the more curious things about investing is that it tends to punish behaviors that work well in other parts of life. Often people put money into investment managers and investments that have recently done well (in other areas of life you obviously pick the people that have done the best) – when in actual fact with your higher entry price you are more likely to have lower prospective returns or will mean revert and you’ll underperform. The reverse is true – when there has been a broad market sell off fear kicks in and you’ll want to sell, which would lock in the loss – in actual fact the prospective return for every new dollar invested in the market has improved.

It is still very hard to have a ‘behavioral edge’ because it runs counter to our natural tendencies otherwise there wouldn’t be an ‘edge’.