I have never thought that you can beat professional investors. The main reason for my thinking is that you are an amateur and they are professionals. It just doesn’t make sense that an individual doing this part-time with limited resources can beat a professional investor with a degree and all the resources and the time to pick stocks.
The other reason why I didn’t think an individual investor can beat an institutional investor is that nobody knows what will happen in future and so picking individual stocks is a gamble in the end. What we do know is that the market as a whole will increase over time. As countries develop and technology moves forward so more and more value is created and the overall market grows. This is one of the reasons why I am a big fan of exchange traded funds (ETFs).
Well recently I listened to a Choosefi podcast that made me rethink my position. The podcast featured Brian Feroldi who made an argument for why you can beat professional investors and the market. This was interesting because I have always wondered why are there so many individual investors. Do they know something that I am missing? So lets explore those reasons.
Institutional and Professional investors
An institutional or professional investor is someone who invests other peoples money. Their main purpose is to invest the companies assets or those it holds in trust for others. There are generally six types of institutional investors: pension funds, endowment funds, insurance companies, commercial banks, mutual funds and hedge funds.
Professional investors have significant resources and do extensive research on a wide range of investment options. They have portfolio managers who meet with the company executives of listed companies. They have specialists in every industry and experts who evaluate individual companies for investment. Institutional investors typically make up more than 80% of the trades on the stock exchange.
The typical argument is that institutional investors are professionals with proper education and training. They have all the tools available to them and have teams of people to do analysis and watch the markets. They have direct access to and sometimes relationship and knowledge of companies they invest in. This is all true and does give these investors an advantage.
The problem is they have a disadvantage. It is their motivation and incentive for investing and their behaviour as investors. This is where you have the upper hand and can beat professional investors.
1. Short term focus
The first and biggest advantage that individual investors have is their long term outlook. Professional investors are driven by short-term decisions that results in a short term outlook. They are measured on short term performance and compared to their peers on a quarterly and annual basis. So their buying and selling decisions are driven by the short term.
They have a clock and defined time periods to show performance, infact they need to show continual performance. This drives them to make short term decisions to maintain this trend. To validate their expertise and knowledge to their investors they often need to be in the hottest stocks at any point in time. Lagging one-year or three-year performance is seen as a sign to the market that these funds should be dumped. Individual investors on the other hand have time and freedom to wait for their gains allowing them to beat professional investors.
2. Large funds can’t invest in small caps
Institutional investors manage very large funds. This limits the types of investments that they can make. Due the large size of their fund, for them to make a sizeable investment in a small cap would be too high a level of ownership. Large funds have restrictions on the levels of ownership they can make. Taking a significant stake has other risks and legal requirements. Smaller caps may also be less liquid especially for large investors. This is partly why they stick to the large multinationals.
3. The size of the fund is more important than the growth
For institutional investors the bigger the fund the better. It means more credibility and more fee income generated. The size is created by securing more funding to buy more stocks. So the key driver is to grow the size of the fund by securing more investors.
The focus is more of a selling job to secure more new investors than it is in structuring the fund to grow. This is opposite to the individual who is trying to maximise growth of their investment. The bigger the fund the bigger the income generated from fees.
4. Those fancy buildings and big bonuses have to be paid for
Regardless of the performance of the fund these investors need to get paid and cover their costs. Then when they outperform the market they attract large bonuses. But if the market underperforms they don’t get penalised. So the resulting fees to their clients erode the returns from the performance of their investments. Warren Buffet took a bet with fund managers where he said that a passive index fund would beat any fund over a 10 year period. Needless to say he was right, you can read the full bet here. The main reason was due to the high fees that these funds attracted.
5. Investors in the funds influence decisions
Fund managers will choose the large well known popular companies so as not to stand out from the crowd. They can be forced to sell out of stocks at the wrong times due to policy requirements or investor or peer pressure. Or even if a client wants to withdraw from the market they need to execute even if the timing is wrong. Individual investors don’t have these pressures and don’t always need to take profits, choosing instead to wait for longer term gains. Often these pros are forced to buy high and sell low as they are forced to buy stocks moving up and sell stocks that are dropping.
Peter Lynch writes about this in his book “One Up on Wall Street”, where he is unable to invest in down markets due to investors requiring him to sell stocks to meet their requests to withdraw money. This was the opposite of what a prudent individual investor would do. He also had to buy at market peaks when stocks were overvalued.
6. Fund manager has a mandate to execute
Besides their clients requests the professional investor has other people to answer to. Even if he knows of stocks that he would buy in a personal capacity he is not able to buy them. Fund managers have to answer to someone else and typically choose safer bets. Their decision making is overseen by different individuals in the organisation.
7. Institutional investor is an employee not an owner
Think about the difference in decision making and commitment and incentives of an employee vs the business owner. They have very different drivers and measures of success. The owner wants to grow, take risks and make money. The employee wants to do as little as possible make as much money as possible for themselves.
Institutional investors are incentivized by growing the size of the fund and the fee revenue that the fund generates. So the incentives of a professional are very different to those of an individual investor. When you are investing your own money it should be no surprise that you can beat professional investors.
Research like a professional but act as an owner
The purpose of this post was not to undermine institutional or professional investors in anyway. Clearly they are the best at what they do and many of them would have above average personal portfolios. The point is that as an informed individual investor you should be able to make and execute a profitable investment strategy. There are no right and wrong answers in investing. Every investor has a different background, motivation, outlook and time frame that they operate in. All these differences mean that success looks different for each investor.
This doesn’t mean that you should rush out and start buying up stocks because you can beat the market. A sound investment strategy that weighs up your risk and requires a proper understanding of what you will be investing in is still required. You also need to be well informed and do your analysis and due diligence to find winning stocks. It also doesn’t mean that you can just rely 100% on picking individual stocks in your portfolio.
Even for some of the best stock pickers out there you will find them with a balanced diversified portfolio where index funds could make up the bulk of their equities portfolios.
The amazing thing about the stock market is that it is unpredictable with plenty of opportunities. It is up to you to find that opportunity and make the returns without risking everything.
