Don't Invest Like The Pros: The Retail Investor's Edge (1/2)

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Includes: SPY
by: Robert Kovacs

Summary

This is the first part of a series of articles for retail investors.

Today we will look at two key differences between you and the pros.

As well as how you can exploit them to your advantage.

What did Buffett add to his portfolio? What did Soros sell? What would John Templeton do?

All over the online investment community, you can see investors asking these questions and debating their favourite gurus' latest transaction on the markets.

Source: CC0 Licence (no attribution required)

While we can all learn by studying industry leaders, many end up attempting to mimic their trades. Some websites even sell you access to all the latest guru trades (they scrape 13F filings).

The appeal is obvious: You get to tap into some of the best investors' minds at close to no cost. Psychologically this is reassuring. As humans, we enjoy being able to follow an authority, it is ingrained in the way we are raised. You can read Stanley Milgram's research on obedience from the last century. Here is the most important sentence from his research:

The extreme willingness of adults to go to almost any lengths on the command of an authority constitutes the chief finding of the study and the fact most urgently demanding explanation

It is no surprise that human behavior in the investing sphere is similar. Otherwise, why would entertainers like Jim Cramer think that Warren Buffett selling a third of Berkshire's (NYSE:BRK.A) (NYSE:BRK.B) IBM (NYSE:IBM) stake is "devastating for IBM" yet he didn't pick up the news when I advised not to buy?

It's called an authority bias.

In my experience, this is a flawed approach to investing for retail investors. Your biases hurt you more than they help you.

I decided to write this series of articles to give us all a road map to successfully investing as retail investors.

In the first two articles, I will be overviewing key differences between you and the pros, and why you have an edge over them!

The main sources of divergence come from different goals and different constraints.

I call this the difference between investing as a business vs. investing as an investment.

Today we will look at how retail investors' goals are fundamentally different from professional money managers' from two angles.

  • Marketing: They're in a competitive business, you're not.
  • Benchmarking: They need to constantly outsmart the competition, you don't.

Let's dive right in.

Marketing

marketing

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This is probably the most important difference between retail investors and mutual funds or hedge funds.

You are saving to meet your life goals, be it a down payment, generating income or setting aside for retirement, whereas professionals are running a business. This implies a few key differences.

Investment management is an extremely competitive industry, where it is very hard to differentiate. In fact, while the number of listed securities in the US has been constantly decreasing since they peaked in 1996, the number of mutual funds has exploded. In 2016, there were 2.59x more mutual funds than listed securities.

Source: Bloomberg

As a result, asset managers need to differentiate as much as possible, by picking:

  • A theme: small cap, large cap, dividend yield, value, growth, GARP, low beta.
  • Performance measures: relative or absolute performance, risk-adjusted performance, etc.
  • A size: either decide to cap AUM at a certain amount or gather assets to increase management fees.
  • A pricing model: Charging a performance fee or not, being a low-cost provider, etc.

This means that they cannot invest at will. I have had discussions with several fund managers who have told me that unfortunately they cannot pursue the best opportunities they find because too often they don't fit into the parameters they have promised their clients.

They must specialize to differentiate in an extremely competitive industry. They define themselves as "Small cap growth" or "Large cap value" or "Core All cap low volatility income." You don't need to pigeonhole yourself.

Why this gives you an edge: Unlike the pros, you are free to run a "common sense" portfolio. Even as your portfolio grows, you will most likely never have a big enough portfolio to exclude smaller stocks from your portfolio. You can also choose to measure your performance in ways that are relevant to you. Stocks that make it to your portfolio will make it purely based on their merits, and no great opportunity will be excluded because of conflicting goals.

Benchmarking

Benchmarking is the process by which you link your performance to an index. The most common index used is the S&P 500. If the index goes up 7% and your portfolio goes up by 5%, you underperformed by 2% despite generating positive returns.

benchmarking

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There is a plethora of reasons why you should or shouldn't use the S&P 500 as a benchmark. Mutual fund managers will always be measured against it. This means that they have an arbitrary measure of whether they have overperformed or underperformed.

You have fund managers patting themselves on the back when they lose your money, because you would have lost more money by investing in the S&P 500. Their relative performance is "good" despite losing money. You should remind them that you can't buy a burger with relative dollars.

You can map your performance against the S&P 500 periodically to see how you are doing. Here is a novel idea: how about benchmarking yourself against your own objectives?

If you have a goal of $2,000,000 by retirement, given your actual portfolio and monthly/quarterly cash inflows, what returns do you need to achieve to reach your goal?

Let's take the example of a hypothetical investor who we will call John.

John started investing 10 years ago, in 2007. He had $100,000 in cash. He saves $1,000 per month. For simplicity in computations, let's assume that he invests the $12,000 at the beginning of each year. At the time John had just turned 30 years old.

John wants to retire by 60 years old with $2,000,000. Simple arithmetic allows us to figure out how much John's portfolio must appreciate each year: 7.27%.

From there he can figure out how much he would theoretically need at the end of each year to reach his goal. Each year he can plot his portfolio value against his target wealth.

Source: Author's Data

The data plotted above represent the year-end values. As you can see, it is not until the end of year 2012 that John finally gets ahead of his objective.

Had he used the S&P 500 as a benchmark index, for the first 6 years he would have thought he was doing well, when in fact he was lagging his goals.

As you know, the stock market is cyclical and you can clearly see this here. Which is why it is important to not be too concerned with a few years of underperformance. Over a ten-year period, you should get a good idea of whether you are on track to meet your objective. If not, it might be time to make adjustments: save more or review your objectives. It is also interesting to note that over the last 10-year period, passive investing in a low-cost vehicle like SPDR S&P 500 (SPY), you would be on track to meet your goals despite investing just before one of the worst stock market crashes.

Now let's take a look at another investor, we will call him Tom. Tom is also 30 in 2007 and starts investing at the same time as John does, with $100k also. But Tom is a dividend growth investor, he wants to live off the income he gets from dividends when he retires. Every month, just like John he adds $1000 to his portfolio and invests the $12k in a lump sum at the end of each year. Let's assume that he purchases stocks which yield 3% on average.

He believes he will have living expenses of $3k a month in current dollars when he retires, which adjusted for inflation of 2% equates to $90K a year in 2036 dollars.

To meet his objectives, he works out that he needs his yearly income from dividends to grow at an average rate of 7.87%. From there he can deduct the target yearly income he needs to match to meet his objectives.

By playing against yourself, you have a clearer idea of how you are doing. "Am I going to be able to retire?" is a question which is much more relatable than "am I beating the S&P 500 on a risk-adjusted basis?"

This will also condition the way you invest. By measuring performance only based on long-term objectives, it is much less likely that you will make irrational investment decisions.

Why this gives you an edge: While the pros are competing on a short timeframe and are compared to a cyclical and often irrational benchmark, you have the luxury of only comparing yourself to your objective. Plus, you get to "cheat." If your performance is below what you needed to meet your long-term objective, you can cut your spending or find new sources of income to add to your investments. When you retire, it won't matter whether the money came from investment performance or increased savings.

Conclusion

As you can see, there are fundamental differences between professional investors' goals and yours. All the literature suggests individual investors mimic the pros, yet there are clear agency problems when you give a money manager your savings.

The fundamental takeaway is that you are not trying to impress anyone with fancy labels and flashy performance. All that matters is that you meet your goals.

The irony is that if your required growth rate for your portfolio is lower than other investors', you are in a better situation than they are since you don't need excessively high returns to live the life you want.

In this article, we have looked at how your goals diverge from the pros. Next week we will look at structural constraints that don't apply to you. We will then look at how you can use this information to build your portfolio from scratch or tweak your existing portfolio.

Here is a quick preview of what you can expect me to talk about next:

  • Quarterly Results: Clients track the pros' performance, every quarter/month/day, you don't.
  • Cash withdrawals: And if they don't do well enough, clients will leave, you won't.
  • Obligation to invest: And if more clients buy into the fund, they have an obligation to invest these new funds, you don't.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.