Where Outperformance Comes From

There's a saying that there's always someone on the other side of your trade, and that someone may know more than you. I thought of this last week while reading the biography of Joseph Kennedy.

Kennedy's wealth came from a mix of genius and a sheer lack of morals. Take this story: The repeal of prohibition in 1933 was bound to benefit companies that made supplies needed to make alcohol. One was a bottling company called Owens-Illinois. Rather than investing in directly in Owens-Illinois, Kennedy purchased shares of a company called Libbey-Owens-Ford. "Libbey-Owens-Ford was an entirely separate company, which manufactured plate glass for automobiles, not bottles, but its name was close enough to the bottle glass company to fool unwary investors," writes biographer David Nasaw. On news of the repeal, Kennedy and his partners traded shares back and forth between each other, pumping up trading volume to draw attention. That caused other investors to buy shares "on the mistaken belief that they were buying shares of Owens-Illinois, the bottle manufacturer." After a surge, Kennedy dumped Libbey-Owens-Ford with a $1 million inflation-adjusted profit and invested the proceeds in his original target, Owens-Illinois.

Almost half of Gen Yers -- those between age 20 and 32 -- say they "will never feel comfortable investing in the stock market," according to a 2012 study by MFS Investment management. They use words like "casino," "crapshoot," and "rigged" to describe the market. They know someone is on the other side of each trade, and that someone -- like Kennedy -- may know more than them.

But there's something every mom-and-pop investor can do to gain an edge on the person on the other side of the trade: be willing to wait longer.

That's it. There are few things more powerful in investing than the realization that the biggest gains tend to accrue to the person who waits the longest. If you bought an index fund 20 years ago and checked your account statement for the first time this morning, you could legitimately call yourself one of the top investors of modern history, having outperformed three-quarters of professional fund managers. You can say this only because you were willing to wait longer than everyone else who trades, fidgets, rotates, sells in May and goes away, and make (small-f) fools of themselves while you let compound interest work.

Most outperformance in the stock market doesn't come from Kennedy-like mischief, but instead from something simple called time arbitrage. It's exploiting the gap between your time horizon and mine. If you're worried about the next six months, but I can be patient for the next six years, I have an edge over you. You may sell shares today because you don't want to have another down month, and I'll be happy to buy them from you to focus on my up decade. That's all time arbitrage is. With a diversified portfolio, anyone can do it, because patience doesn't require inside information, fancy math models, or high-frequency trading algorithms. All you have to do is wait. It works best with an indifference to short-term volatility that borders on obliviousness.

Companies didn't report much information in the 1930s, but archive documents show Libbey-Owens-Ford earned somewhere around $1.1 million in profit in 1933. By 1985, profits were more than $70 million. Getting tricked by Kennedy didn't matter much if you were willing to wait.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

The article Where Outperformance Comes From originally appeared on Fool.com.

Contact Morgan Housel at mhousel@fool.com. The Motley Fool has a disclosure policy.

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