As a student of the market, I just finished reading an excellent 97-page report by Michael Mauboussin of Morgan Stanley titled “Who Is on the Other Side?” 97 pages may sound intimidating but for market nerds it is the good kind of long, the kind that pulls you in so completely you forget coffee exists until you realize it is gone cold on the desk.
Well, this is the kind of report that does not try to impress you in the first five pages. It earns your attention slowly, then refuses to give it back.
Here is a section:
Let us go back to investing in individual securities. The question you should ask every time that you anticipate excess returns when buying or selling is “who is on the other side?” The goal is to understand your counterparty’s motivation to act and assess whether you have an edge.
Ed Thorp, a mathematician and hedge fund manager with excellent returns, claims that you have an edge only when you “can generate excess risk-adjusted returns that can be logically explained in a way that is difficult to rebut. In other words, you can articulate why an inefficiency exists and how it will be extinguished.
Gaining edge is hard. For instance, the anomalies that academic research finds do not provide the same returns in practice as they do in theory. One reason is statistical bias: with lots of data and lots of relationships, some factors will correlate with attractive returns by chance and lack predictive value.
Accordingly, some researchers suggest academic journals should raise their hurdle of what constitutes a legitimate factor. Smart investors also exploit the factors that do predict excess returns and therefore compete away the opportunity. This is especially true if investors can identify and capture them at a reasonable cost.