This one weird law can boost your portfolio

Why is Snap Inc. taking such a battering?

What if I told you there was one weird law that unlocked this secret? (But, sadly, it won’t do anything about belly fat.)

What’s more, this law applies to investing in many markets. You might be surprised to learn that such a wide variety of industries tend to exhibit the same pattern of behaviour. However, it’s entirely accurate to use the same law across many investment sectors.

It’s called the power law (power as in maths y=x-k – not as in electricity, or might)

You might know it as a long-tail distribution, or the 80/20 rule. It applies to a very wide range of datasets – everything from the size of cities to the diameter of meteor craters. Simply put, you ordinarily get a few big things, and a lot of small things. That’s as true of book sales as it is of floods or storms. For every Harry Potter, there’s a slew of books on critical feminist theory, which hardly anyone buys.

This law is something I’ve been sitting on for quite some time, and I ought to have brought it to your attention earlier. It was introduced to me by an American investor, who helped me understand something I already kinda knew – but with a much clearer focus.

Right now, this law can explain why Snap is having such a difficult time. Yesterday’s darling has recently announced some very poor results – leading to a precipitous drop in the stock’s price.

Why am I telling you about losing stocks?

If you caught this drop, you could have made a great trade, by shorting Snap. Backing winners directly isn’t the only way to play a market, and a short is equally valid. Simply put, shorting allows you to sell a stock you don’t own, then buy it back later. If the price falls, you can make a killing – but get it wrong, and you can face unlimited losses. It’s a strategy that’s not for the faint-hearted, and typically merits judicious use of stop-losses. Now, back to how to pick the winners (and losers) to trade…

How does the power law explain why Snap is struggling to make headway?

Simply put, the power law explains that the value of companies in a sector tends to fit to a mathematical function known as a power law curve. Although power law functions can change in their shape with different parameters, we can keep things simple – because that makes the power law function a whole lot more useful to investors.

Without going into detail about the mathematical properties of how power law curves are derived, one crude rule of thumb to explain how they’re used in investing is this: the value of the largest company in many industries is typically larger than the sum of the value of all its competitors. This is true in sectors which have some tendency towards concentration (ie, dominated by a few large firms). If you think of the leading tech companies, then they tend to follow a power law distribution, expressed in that relatively accessible way. I haven’t done the maths for each of the below sectors, but I hope you can intuitively see the logic.

Facebook is likely worth more than all the social networks in the world put together: LinkedIn, Twitter, etc. That’s why Snap is really struggling to overcome its might.

eBay is the probably the largest second-hand goods market in the world, eclipsing the sum of all others: Depop, Auto Trader, etc.

Amazon is certainly the largest ecommerce retailer in the world – and its value is likely higher than the sum of all other competing e-commerce retailers: Boohoo, Wicked Uncle, Figleaves, Etsy, etc.

The point of making such a play of the power law is that it drives home the importance of picking winners. Number two in a market is nothing. Second place is a fail, time to go home. Only backing the winner will really yield any significant buy-and-hold investment returns.

Of course, a well-timed investment in any firm can lead to profit. However, if you’re a long-term value investor, picking between firms that are on the up, it’s essential to remember that only the star of the group will have any meaningful return at all.

What does this mean for your future investment strategy? Check back tomorrow, where we’ll discuss in depth how to trade using the power law.

What do you think of this one weird law – andrew@southbankresearch.com.

Best,

Andrew Lockley
Exponential Investor

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