The Law of Small Edges and the Need for Financial Education

By Bob Huxford

There is often an underlying suspicion of London as the place that took everybody else’s money that emerges in conversations I have with non-Londoner friends. This becomes much more conspicuous if reference to me working in the financial sector is ever introduced. The opaque world of finance has often been viewed from outside as unprincipled, and to some extent unnecessary, (dodgy traders creaming money off the top while producing nothing of worth to society) but this perception seems to have steadily worsened since the crisis of 2007 and is becoming ever more pronounced in our social media-led age of conspiracy and polarisation. 

A friend of mine who works outside the financial sector was berating me - again - the other day as an immoral enabler of City types who are stealing all the cash. "The stock market is rigged.” he said. “How can it be fair if all these equity analysts know what you're supposed to Buy and Sell." The simple truth is, of course, that they don't. 

An analyst doesn't know exactly what to buy and sell. If he or she did they most likely wouldn't be telling everybody about it but would be hoarding this divine knowledge while becoming disgustingly rich.

What analysts do is pour over information on the finances and operations of listed businesses, as well as the markets in which they operate, in an effort to ascertain their value. These valuations are based on a combination of the company’s prospects and the value the market places on comparative businesses. This is not an exact science. However, if there is a discrepancy between the analyst’s and the market’s valuation this could potentially be valuable knowledge, assuming the analyst has done their homework correctly.

The information they look at is publicly available and any one of us, including my distrusting friend, could choose to do it, if they could be bothered and took the time to develop sufficient financial acumen.

Most of us can't be bothered of course and, in reality, simply don't have time as we have other jobs to attend to. Even fund managers don't have time to examine in minute detail all the companies they invest in, which is a key reason for the existence of the equity analyst role. The analyst condenses the detail into a digestible format providing estimated price targets and recommendations, all of which helps the fund managers make sensible choices so they can grow rather than fritter away our pensions.

When I briefly worked as an analyst, back in the mid-noughties, one of the first things I was told was that: "if you’re correct in your Buy and Sell recommendations 5% more of the time than you’re wrong, you're doing great." At the time, I failed to compute how this could be true. What's the point of me as an analyst if I'm giving out information that has little more than a 50% chance of being correct? Any person at random could achieve that level of success, with a little luck. 

However, a small edge of 5% adds up to a lot over time. The two green zeros on an American roulette wheel provide the house with a 5.26% edge, and this is all that's required to guarantee the casinos make money if a customer spins the wheel for long enough. The whole of Las Vegas is pretty much built on the takings from those green zeros and, just like the casinos, that 5% edge is all that's needed to help fund managers invest in the right companies and slowly nudge our pensions in the right direction. 

There’s nothing underhand going on, the markets rely on honesty and couldn’t attract investors if they couldn’t be trusted. Likewise, in the casino, those two green zeros are in plain sight and it’s entirely up to the punters if they choose to gamble knowing the odds are against them.

This is the same with the stock market. You can be like the punter in the casino and gamble on stocks off the back of a hunch, or you can take a considered approach, put in the research and gain yourself an edge against the gamblers. There’s a lot of information out there on companies and lots of resources online that can help all investors make better informed decisions. As with anything in life, the more effort you put in, the more you’ll get out.

The point of all this is that the growing distrust of the financial markets is corrosive, unhealthy and largely misplaced. I’ve mentioned in prior blog posts that I think the UK would benefit enormously from providing some level of financial education in schools. This would help all of us make more considered financial decisions in later life; better prepare us for jobs in the financial sector, which employs 1.1m in this country; and help replace the mistrust with a pride in our financial services sector, which is one of the best in the world, and, at 7% of GDP, is something we all rely on and should support.