4. The complete process, and where to go from here

Level 12: A process that survives

The course is coming to an end, and this is the place to take stock of what you are carrying, turn it into something you can use on Monday morning and say clearly what comes next.

The six levels, on one page

• Where an edge can exist (level 1): the four families of edge, what each one demands and why most private investors have none of the first three and can indeed have the fourth.
• Why the market erases it (level 2): what it really means for a market to be efficient, and why the limits to arbitrage explain how price differences can persist without anybody being a fool.
• The premia with names (level 3): what a factor is, which ones have survived scrutiny and why collecting a premium for taking on a risk is not the same as exploiting a mistake.
• Why it gets used up (level 4): publication, crowding and capacity, the cycle that turns a finding into a product and a product into a mediocre result.
• The playing field (level 5): how the index is built, who buys out of obligation and what consequences that has for whoever is not obliged.
• And this level: refutable hypotheses, self-deception and abandonment.

Note what is not on that list: no specific strategy, no model portfolio and no promise. What there is, is a filter for looking at any idea, your own or somebody else's, and knowing what to ask of it.

The process, numbered

1. Write the idea down as a hypothesis. Universe, exact rule, horizon, comparison and expected magnitude. If it does not fit into a paragraph another person could carry out, you do not have it yet.

2. Name the one on the other side. Who is selling cheaply and what constraint is making them do it. If you do not know, do not go on: the one who is wrong is you until you prove otherwise.

3. Write the refutation condition. What specific observation would make you abandon it. Without that line there is no hypothesis.

4. Note down how many variants you have tested. Before looking at any result. It is the figure that determines how much distrust the best of your attempts deserves.

5. Raise the bar in proportion to how much you have searched. The more you explore, the more extraordinary the evidence has to be for you to believe it.

6. Check the capacity. How much money fits before your own trading eats the edge, and how much the rest of the market is already carrying.

7. Size to survive the worst plausible case, not to maximize the best one.

8. Record the decision before the result, with a declared confidence and a time frame.

9. Review the mechanism on a fixed date, answering in writing whether the reason has changed, whether it has become crowded and whether the structure of the market has changed.

10. Separate the decision from the result when you evaluate. A winning trade with the hypothesis refuted is a bad sign, not a good one.

Ten steps and not one of them requires a computer. They require writing, which is rarer.

Where to go next within the academy

If any part of this course felt too dense, there are three courses without code designed to get you here with more grounding. Market theory explains how a price is formed, who takes part and what each type of order really does. Macro covers the price of money, central banks, the cycle and inflation, and it is the one that gives context to the idea of a regime. Costs is the most thankless one and the one that saves the most money: fees, spreads, taxes and the cumulative effect of all of it over decades.

If what you want is to measure rather than to reason, the next rung up is three intermediate courses. Mathematics and statistics turns this level's warnings into numbers: significance, multiple testing, out-of-sample validation and confidence calibration. Derivatives explains options and futures, and why selling a small, steady premium is not a low-risk strategy. Risk and portfolio management tackles step 7 seriously: sizing, diversifying properly and understanding what happens when correlations go to one.

And the first half of this same course, levels 1 to 6, was exactly that: expectations and reverse valuation. This course asks whether there is an edge and how long it lasts; that one asks what exactly today's price is pricing in, that is to say, what the company would have to deliver to justify what it costs. They are the two halves of the same question, and they complement each other well.

Real case: ten years, a bet and a process

In 2007 a public bet was struck, with a million dollars at stake, between an investor known for his preference for indexing and a firm specializing in selecting hedge funds. The question was simple: over the following ten years, would a cheap index fund on the US index make more, or a basket of funds of funds chosen by professionals?

When the period closed, at the end of 2017, the index fund had accumulated around 125% and the average of the selected portfolios came in at around 36%. The difference is not explained by the managers being incompetent: many of them were good. It is explained by the sum of the three things this course has kept repeating. Their edges, where they existed, were known and were crowded. Their layers of fees consumed a good part of what was left. And the period chosen rewarded precisely what they were not doing.

The lesson is not that active management is useless. It is that an edge has to survive costs, competition and the regime, and that whoever does not write down in advance the conditions under which they expect to win cannot know afterwards whether what happened confirmed or contradicted their thesis.

A warning that is not a formality

All of this material is education, not financial advice. Nothing you have read is a recommendation to buy, sell or hold any security, nor is it adapted to your situation, your objectives, your horizon or your risk tolerance. The historical cases are used to illustrate mechanisms, and the fact that something happened that way once does not imply that it will happen again. Investing carries a risk of loss, including the total loss of your capital. If you are going to take decisions with real money, do so with your own analysis and, if you need it, with a professional authorized to provide it.