Monday, April 7

4 advantages of small-time investors

4 advantages of small-time investors
Business Week | By Charlie Bilello, U.S. News & World Report

You can beat the pros at their own game if you extend your time horizon, exercise patience and look for ways to move against the crowd when opportunities arise.

In most fields, professionals or industry experts have a clear advantage over the average person. We know this to be true in medicine, law, engineering and other vocations in which the learning curve is high.

Contrary to popular belief, investing is not one of these fields, and in fact, the opposite is often true. A little bit of knowledge can be a dangerous thing in the investment world.

Before you jump to conclusions, I am not suggesting that the average individual outperforms the average professional investor. This is likely not the case. What I am arguing is that the potential is there if individuals can avoid the emotional biases that hurt all investors while capitalizing on certain inherent advantages that individuals possess.

What are some of these advantages?

The most important element of successful investing is time. Even if you have an effective investment strategy, you still need to have enough time to benefit from the long-term compounding of returns. The advantage that many individuals have over professional investors is that their time horizon is often significantly longer.

History has shown us that the longer your time horizon, the higher your odds of achieving a positive return. For example, since 1900, the Standard & Poor's 500 Index ($INX) has been higher in 64 percent of rolling 3-month periods. If you extend the holding period to 12 months, this improves to 72 percent. If an investor committed to a 5-year holding period, an investment in the S&P 500 index would have been up 89 percent of the time. A 10-year holding period improves to a 96 percent success rate and if you held for a 20-year period, your return in the S&P 500 index would have been positive 100 percent of the time.

Meanwhile, many professional investors, particularly hedge funds, are operating on a monthly performance time frame in which their performance is judged. This can often lead to suboptimal investment decisions in an attempt to manage the monthly performance number. This is perfectly rational behavior for these hedge funds, as their businesses cannot afford a string of poor numbers, even if it means that long-term returns would increase. For these funds, there is no long term without the short term.

Individual investors, of course, do not have to worry about reporting a monthly number and can invest to maximize long-term returns.

Knowing you have time on your side is one thing, but having the patience to sit there during the inevitable periods when you lose money is quite another. Many professional investors lack patience, as they are not afforded this luxury by their clients. Again, this can lead to suboptimal behavior and abandoning an otherwise successful strategy at precisely the worst time.

A clear example of this would be the fall of 2008, when many long/short hedge funds had to sell down their long investments in order to minimize risk and keep their investors at bay. At the same time, individual investors could have done the opposite, and increased their long-equity exposure knowing that it was likely to hurt in the short run, but benefit from long-term returns.

A third advantage individual investors have is that they can go against the crowd when valuations are at an extreme. Professional investors often suffer from herding, or the concept of gravitating to similar investments of other funds. They engage in this behavior because the career risk from deviating from the crowd and being wrong can mean the end of one's career, even if it is the correct decision in the long run.

An example of this today would be the emerging market equity space. In spite of these investments' significantly cheaper valuations than U.S. equities, you'll find few professional investors with a bullish outlook on these shares.

The reason for this is simple. While the S&P 500 is up over 47 percent over the past three years with overwhelmingly positive news, emerging markets are down 15 percent and have the backdrop of extremely negative news. If a professional investor were to deviate from the crowd here and buy emerging markets, they would be highly penalized if the trade did not immediately work.

Their investors would have little patience for losing money in a trade that was so obviously (in hindsight) wrong. The implication here is that because emerging markets have been underperforming by such a wide margin, that the professional investor should know better than to invest in that region. Thus, regardless of the long-term return potential, professional investors will avoid emerging markets until prices advance and the news gets better. By this point, though, much of the original opportunity will have passed.

Professional investors are often paid to be specialists or experts in a certain area of the market, whether it be an asset class, a sector or a security. This expertise can come at a cost when a better investment opportunity lies elsewhere. A good example of this would be in 2000, at the height of the dot-com bubble. A professional investor that focused on long-only investments in the technology sector would have no way of avoiding the ensuing crash.

The pros are also constrained by size. When assets under management reach a certain level, smaller or less liquid opportunities are no longer an option for these funds. At times, these smaller opportunities are extremely compelling, offering the best long-term returns. Individual investors do not suffer from size limitations and can (in theory) go to wherever the best opportunity is.

Bottom line: Although these advantages are available to all investors, they are significantly underutilized. The average individual suffers from the same negative behavioral biases as professional investors. Indeed, the average holding period for stocks has continually fallen over the past 50 years, from over eight years in 1960, to less than a year today.

With increased access to information and lower costs of trading, investors have become their own worst enemy. They are relinquishing any advantage they might have over professionals in believing they can improve their returns through increased trading.

An intelligent investor would do well to stop trading without a strategy and recapture their inherent advantage by extending their time horizon, developing a more patient outlook and looking for ways to move against the crowd when opportunities arise.

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