The private investor's advantage
Filed under: Investing
One camp holds: 'Don't even try'. That way lies the expense of overtrading, and the risk of trying to be too clever. Better to construct a sound, diversified portfolio, and then patiently let time grow your wealth by the magic of compound interest and dividend reinvestment.
I guess I have a foot in both camps. I put a lot of thought into asset allocation, which I think is the most important topic in investing. And I put a lot of my money into solid defensive stocks that don't need much care and attention. I'd like to think they'll flourish under careless neglect at least, as well as the ragged green patch that passes for my garden.
But I am an active investor, and surely the point of that is to generate the best return I can. Though I don't explicitly measure my performance against any benchmark, implicitly I'm trying to beat what average investors do.
Isn't that incredibly conceited? However clever I may be -- and I don't have great pretensions in that direction -- how can I expect to make better investment judgments than professional fund managers? Apart from the question of ability, I can't possibly hope to match the amount of time and resources professional firms devote to research, nor their specialisation.
It is professional fund managers who I must judge myself against. They, by and large, make the market. Passively managed funds, such as index trackers and ETFs, make up just a small fraction of the total funds under management. Their valuations are simply the average of prices made by (indirect) trading between active fund managers and other institutions.
So the average performance of active fund managers is bound to be, well, average. In fact, the latest research from Lipper shows that typically around 40% of actively managed equity funds outperform their chosen benchmark, in the most recent three years, and also in one-, three- and 10-year rolling periods over the past 20 years.
It's a fairly consistent statistic, but why are only 40% above average and not 50%? We all know it's down to the drag of active fund management costs. And that's the first advantage I have as a private investor. All that DIY research saves me the 1.5% or so a year that active fund managers charge.
Not paying charges make a considerable difference to performance. But I'll still only beat the market if I'm as good as the 40% of active managers who outperform the trackers. So I need something extra.
I think the biggest advantage I have is that I can, genuinely, take a long-term view.
Professional fund managers face constant scrutiny of their performance. For them, it's not just a question of making the right call, but of convincing their bosses, peers and clients that they are right. It is harder to defend a position that is under water than it is to report short-term profits. Inevitably, short-term considerations assume a disproportionate importance. It's classic City short-termism at work.
Indeed, I wonder if one of the things that help create star fund managers such as Neil Woodford or Anthony Bolton is that, having once established a reputation, they are better able to defend their positions.
Taking a long-term view suits both value and growth investment styles. Value investors can sit patiently waiting for the value to out, while growth investors can see valuations catch up with increased earnings.
But nothing says you can't also take advantage of short-term trends. So you can top up when favourite stocks are trading at a low, or take profits when they're riding high. A long-term view simply gives you more options. Having more options should improve results.
The flexibility to invest in whatever takes my fancy also gives me more freedom than a professional fund manager, who is bound by the fund's mandate. I can freely allocate and reallocate assets to whatever class I choose.
Perhaps the most important flexibility I have is to hold cash or, in other words, to put money in or take it out of my portfolio. Though fund managers can hold cash, investors look askance if the holding is large. Why pay a manager to put your money in a bank account?
I can withdraw funds from the market when I'm feeling bearish, and reinvest when I'm bullish. Fund managers must really envy that. Trackers and ETFs are automatically fully invested. Of course, to properly compare my performance with the fund manager, I have to include the return on my cash holdings.
Saving costs, the luxury of a long-term view, and flexibility to hold cash -- those are the three big advantages I have as a private investor. So I don't need to be clever to beat the market.