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Non-consensus investing

If there is one thing you take away from today's blog, it should be that to beat the market you need to understand the consensus and then create an edge for yourself that allows you bet against it and win.

We have been leading up to this article over the previous 91 articles and last two years of the blog. Over that time we have discussed the old and new brain, how people make forecasts, how we update our understanding of the world, how we act in groups, how to improve our emotional intelligence, the science of propaganda and how to overcome the urge to make mental shortcuts and save mental effort and energy. Now we can apply that to the specific domain of investing.

What does it mean to beat the market

Whether you call it edge, alpha, excess returns or active returns beating the market means making good investments in a way that yields above average returns. There are many smart people who believe that no-one can outperform the market. Their view is that markets are efficient and all relevant information is contained within the market price. I disagree with that view and believe that creating value is to quote Richard Oldfield ‘Simple But Not Easy’.

Key questions for today will be 1) what is a consensus? 2) why is it often wrong? and 3) how you can generate an advantage by betting against the consensus?

What is consensus and how can it be wrong?

Consensus is a general agreement or a common sentiment within a group. In financial markets it tends to mean that there is a common opinion on the future prospects shared between a large section of the investing community. This drives market pricing.

When a market comes to a consensus many people just accept that the consensus is likely right. They conclude that the collective wisdom of many smart people has come to the best estimate available.

So how do we make sense of this wonderful chart from James Eagle? In the chart below the white line is the actual Bank of England policy rate, and the offshoot blue, purple and red lines were what the market expected future rates to be. What it shows, is that the consensus priced in rates to rise a lot between 2009 and 2020 - but they did not. The markets then wrongly priced rates not to rise too much and then swiftly fall but did not. The consensus view of the future was wrong EVERY time.

So why might the market consensus be wrong? Here are some examples:

  1. The way a market works has changed and market participants hold an outdated view of how things will pan out (we have seen that recently with most investors wrongly believing that central banks were keen to start cutting as soon as they could)

  2. Most investors are using the same data sources and are not coming to independent views (people are hanging on every word of the Fed)

  3. Events previously thought unlikely, happened (how do you price in pandemics, wars or supply chain disruption?)

  4. Factors not generally thought about (e.g. investor preference, behaviour or regulation) changes demand or supply of the investment and therefore the price.

Why non-consensus thinking leads to better outcomes

An investor can follow the consensus or bet against the consensus:

  • Following the consensus means you are following the market. You should expect to get an average good result if it goes well or an average bad result if it goes badly.

  • Going against the consensus means if you are right, the market moves towards you a lot more as investors are 'surprised' and many investors need to change their position. This leads to above average positive results. If you are non-consensus but wrong, the market had already priced in a high probability of another event happening so you will lose slightly less than average.

When should we bet against the consensus?

We know consensus is often wrong and it can pay handsomely to bet against it. Why do people find it so hard to bet against the consensus?

Firstly, the consensus prices in commonly available information. So people who do not have some sort of clear edge over other investors do not feel confident to take a contrarian view.

Secondly, even if we feel things will happen differently, we are herd-following animals. We find it tough to be isolated - physically or cognitively. We are wired to feel more confident in our views if others have come to the same conclusion. On a more practical level, the consensus is taken as true by media outlets and they parrot the same information. Many voices saying the same thing makes it feel risky to bet against the consensus. We are also worried about looking like a fool. John Maynard Keynes sagely said “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

How to find market-beating edge

An edge in my opinion is a superior and non-consensus view. One problem however is It is hard to say in advance whether your decision-making is good or not. Only successful track records over the long-term can provide an indication.

Creating an edge requires using second-order thinking. When events have happened, investors have false confidence of being able to have seen them coming, but when faced with the future they see a wide range of possible outcomes. Understanding what might happen and how likely it is, is the key to making good decisions. Importantly, not everyone agrees on what that range of possible outcomes looks like.

I see 4 key pillars of edge:

1. Psychological and emotional edge

  • Be an independent thinker less swayed by the consensus voices e.g. are impervious to the consensus media

  • Analyse in an emotionally neutral way e.g carrying out analysis without bias

  • Be patient when opportunities are thin on the ground e.g. know when to sit on your hands

  • Be bold when excellent contrarian opportunities arise e.g. know when to take action

  • Accept you are wrong without your ego getting in the way e.g. take your losses

  • Be disciplined in pursuing the best opportunities e.g. judge well whether you have developed a higher order insight or not

2. Information and analytical edge

  • Use only information you trust e.g. appreciate that bad data in = bad insight out

  • Synthesise many perspectives from good sources into a coherent view e.g. piece together and make sense of the testimony of others

  • Use more processing power can allow you to discern insights from disparate, unstructured or very large data sources. e.g. "quant" edge is exploited by an increasing number of funds

  • Seek private sources of information to help get more insight e.g. timely, detailed or granular data to help you better understand trends

  • Learn from history to understand how similar situations have played out

  • Use alternative data to refine your probabilities of scenarios happening to provide an information edge e.g. sentiment analysis, satellite images etc.

3. Systems thinking

  • Connect the data more intelligently to describe the system you are operating in and how that is impacted by changes e.g. can join the dots in a more intelligent way

  • Be able to creatively develop new scenarios that have not happened before based on your knowledge of the system and relating to other similar systems e.g. having a firm grip of relevant mental models in science or nature

  • Seek exploitable patterns and relate back to the system you are working within e.g. look for seasonal, mathematical or multi-dimensional commonalities

  • Ensure that your systems thinking includes your investors. They should be well prepared for the sharp price movements or inability to get their money back in certain environments. i.e. taking advantage of the opportunities is easier when expectations are aligned.

4. Reputational edge (this might be a surprise for analytical types)

  • Developing a brand in an area that makes people come to you with ideas further enhanced by having been in a market for a long time e.g. many examples of hedge funds who have developed niches

  • As with everything human, your reputation might help or stop you from getting access to deals. A reputation of being fair, quick, trustworthy and smart will make you an excellent partner. e.g. think long term with relationships

  • Having a broad set of well connected people that know what you can do is a great way to attract opportunities towards you. e.g. make your funnel as wide as possible

An alpha checklist (inspired by Howard Marks from Oaktree)

Whilst having good analysis is great, having the right questions can make sure you are on the right track. Howard Marks, is a true great for this, so here is a good starter list:

  1. What are the range of outcomes that you think might happen?

  2. Which outcome do you think will occur?

  3. What is the likelihood you are right?

  4. What does the consensus think?

  5. How do your expectations and probabilities differ from the consensus?

  6. How does the current price reflect the consensus, and how will it perform under your expectations?

  7. Is the consensus too optimistic or too pessimistic?

  8. What will happen to the price if it follows the consensus and what happens if it follows your views?

  9. How can you make money from this difference?

So what?

  1. Consensus is seen to be most likely right, but can be wrong due to factors like market changes, reliance on similar data sources, unforeseen events, or overlooked factors.

  2. To beat the market you will need to understand the consensus and develop an edge to make successful bets against it. Challenging the consensus can lead to better outcomes, with potential for above-average returns.

  3. Four pillars of edge are psychological/emotional strength, information and data analysis, systems thinking, and access to people and deals.

What have I missed? I would love to hear from the many experts out there.

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