Back of the Napkin #6: Know Your Edge
Part 1: Do You Have One?
Happy New Year! Apologies for the extended hiatus - we were both traveling, and fell out of the habit of publishing, but everyone’s back and we are plowing ahead. We are making some small changes to the format – instead of starting with the transcript up front, we’ll start with a brief discussion of the topic before jumping in. If you have feedback, please reach out to either of us!
We all compete in some kind of games – whether they are actual games (chess, poker, Starcraft), or game-like competitions (trading & investing, status, career climbing). If we’re trying to win, improving our own skills is important, but everyone we’re competing against is also hard at work improving as well. It’s an unending rat race of self-improvement. How do we get ahead?
Answering that question lies at the heart of knowing your edge – the topic of the next section of the podcast:
Jeremy: And so I think I take comfort in, "Oh, this is a really messy situation and I totally understand why other people's incentive structures don't allow them to fix this problem and why I can uniquely." And so that's why I think it's easy to make low-risk investments, if you like, understand things that way. Do you have a very good explanation? Yes, I got paid for this because I did these three or four things. And there's these five different stakeholders, and they all wanted these different things, and I figured out how to solve it and it unlocked this log jam. I like things that are very explainable, when it comes to investing at least.
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Goes to my other question, I always ask investors what is their edge. And I'm always shocked how few have a cogent answer. And maybe it's because people don't think about it, you can just say I'm smarter than everyone else and that might be true. That could be your edge. There's certainly cases of that. But you should have some reason why you think you can do better than everyone else. Even if it's just your cost of capital, it can be anything, but most people cannot articulate why they're better than the next person, which I think is crazy in a business where you get paid for beating a benchmark.
Why is knowing your edge so important? Edge is what tilts the odds in our favor, changing the results from purely random, to positive EV over time. If we don’t know what it is, we might actually not have any edge, at which point we’re just chucking dice and hoping for a good outcome.
Your edge could be skill – that you’re the smartest or most talented person (but you should be brutally honest with yourself here, because this is by definition unlikely!). Building an edge purely on skill is hard because you’re competing against everyone in the world. You need to believe you have some truly herculean work ethic or innate advantages to win purely on skill. Are you truly the Michael Jordan or Lebron James of whatever game you’re playing? (Even if you’re not, it can help to believe you are.)
But your edge doesn’t have to come from raw skill. It may be access to capital (being a billionaire provides access to deals others don’t have). It may be having different time horizons (if you don’t need returns or cash flow now you can afford to wait ten years for venture capital to pay off). It might be material non-public information - edges don't have to be legal! Alameda Research’s edge was being able to go negative, and make up the difference with customer deposits on FTX.
Edges can also be combinatorial. The Diff writes:
Pairing a narrow, domain-specific skill with one that has broader applications—where, depending on the domain, broad skills could include sales, writing, programming, or accounting. The goal here is to optimize for situations where someone wants the best Y conditional on being very good at X—a 90th percentile geologist who can make an effective presentation, a 90th percentile data scientist who can summarize results in a succinct memo, a 90th percentile hardware designer who can understand whether a given design can actually be cost-effective at scale, etc.2
Whatever your edge is, to know it means to understand why you are uniquely suited to win/profit/succeed. It’s surprising how few people have a clear answer when you ask them to define their edge. If you can, you’re a step ahead of most, though that raises a question: if you know your edge, how do you use it?
The answer lies in opponent selection.3
But that’s a discussion for part two – stay tuned for next time where we discuss how to apply your edge (and some difficulties you might run into). Until then, we’d love to hear from you… what’s your edge?
The rest of Jeremy’s response is excerpted out here, and discusses Joel Greenblatt’s book You Can Be a Stock Market Genius, which covers things like merger arbs, warrant offerings, spinoffs, and more.
Patrick: [00:07:05] So it's something like Greenblatt's, You Can Be a Stock Market Genius, your favorite book on investing ever?
Jeremy: [00:07:10] Yes, that is my favorite book on investing ever. The big thing that really turned a light bulb on for me in that was when Greenblatt would describe things like index or a mutual fund has to dump this because they have some weird legal thing about what they can or cannot hold. Okay, so now I understand and I like that certainty. It's boring. I do view it as construction work.
It's not glamorous, like macro or something, but it is very clear and understandable, and you can still make astonishingly good returns because at the end of the day, they can be difficult problems to solve. And even in the Greenblatt instance, you're probably one of a hundred people who is actually reading the 150th page of the legal offering of the warrants offering or whatever, right? And so maybe that's your explanation for why you get paid because you're the only guy who's going to read 150 pages of a rights offering of a small cap. That's a good explanation.
One amusing example of combinatorial edge comes from the world of esports when over a decade ago, one of the top Chinese DotA2 players, xiao8, went on a dating show, and claimed “Guys who are better looking than me couldn't play dota as good as me, and guys who can play dota better than me isn't as good looking as compared to me.” Boom, combinatorial edge! The VODs have been lost to the sands of time, but the original Reddit discussion still exists here (replete with typical gamer misogyny so be warned), and includes another fun fact: xiao8’s salary at the time was 10k RMB a month or roughly $17k USD a year! Esports salaries have come a long way.
Also known as “table selection” in games like poker (choosing which poker games to play and which to avoid).
Great topic! Years ago, a manager described a strategy for finding a combinatorial "edge" as looking at different overlaps with ikigai and it really resonated