Your Unfair Advantage Over The Market

Summary

• Retail investors are at an inherent advantage in the market.
• Working in your favor are the risk/reward imbalance and the law of averages.
• It takes less energy to take action than it takes discipline to do nothing.

Ahhhh. The ambrosia of sloth and unbridled greed, mixed in equal measure and sprinkled like pixie dust onto your burgeoning personal balance sheet. But just as you curl up before the crackling fireplace with your favorite spreadsheet and a cup of hot chocolate, ready to transport yourself into a blissful fairy tale of above-average returns, you're rousted by a displeasing blast of Arctic air! And then, a cabal of financial service providers barges unceremoniously into the room, waving studies that show how average retail investors tend to lag the performance of the overall stock market. They gleefully tout these sobering findings as incontrovertible proof that individual retail investors are at a structural disadvantage in the marketplace, and therefore require the assistance of paid experts and helpers.

The irony, of course, is that the truth is precisely the opposite. Think about it - the most you can lose on a stock is 100%, but the most you can gain is limitless. This is why shares of stock, which offer limited liability to shareholders, inherently skew the risk/reward equation in favor of the shareholder. Think of it this way. Imagine that you have two upside down cups in front of you, and under each one is a share of stock in one of two different companies. You can't see which share of stock is under which cup, but what you do know is that one stock is very likely going to zero, while the other is equally likely to deliver returns of at least 101%. The imbalance of upside versus downside risk in this game makes it likely that you will win at least 1%.

In the real world, obviously, it is extremely unlikely that you could ever pick only two stocks and know ahead of time that one would soar and one would tank. So, let's make the game more realistic. Imagine the same game as before, except this time you have 100 upside down cups in front of you. Under each cup is one share of stock in each of 100 different companies representing every industry that exists. You cannot see which stock is under which cup, but you know that at least one is very likely to go bankrupt, at least one is very likely to soar, and up to 98 are very likely to perform exactly average compared to the overall stock market. You will immediately notice that this game has the same risk/reward imbalance as the first - the only difference is that the skewed risk/reward of the bankrupt stocks and the super-performing stocks gets diluted by all the average-performing stocks.

The other thing you notice is that in the game of 100 upside down cups, your expected returns may be slightly higher than the expected returns from a game that guarantees you only average returns. Let's assume for the sake of argument that the "average" market return is 7% - and that is the return you will earn on 98 of your 100 cups of stock. If it is more likely than not that every loss on your bankrupt stocks will be offset by any gain over 114% on one or more of your super-performing stocks, then the 100 upside cup game has better odds for you than a game that's likely to earn you exactly the market average (and with history as any guide, 7% returns on average is a reasonable guess).

If you believe that in the real world investing is anything like the 100 upside down cups game, then you can rationally conclude that the odds are stacked in your favor to beat the market. You simply need to conform your behavior to maximize your edge over the market. How?

First, you need a large enough, diverse enough pool of stock to increase your likelihood of finding at least some shares that will deliver returns outside the bell curve of average. That's easy. With a large enough and diverse enough portfolio, you are almost bound to hit at least one Amazon (AMZN) and one Sears (OTC:SHLDQ).

Second, you have to assume that the likelihood of bankruptcy is more than offset by the likelihood of super-return stocks that deliver returns of at least 115% (again, I'm assuming the average returns on the market are 7%). This is an easy thing to accomplish because all it requires of you is waiting. Almost no stocks will jump 115% in a day, but over the last 8 years, the average stock in the USA has returned 115% - a chart of the Vanguard Total Stock Market Index drives the point home:

With enough time and a diverse enough portfolio, the odds of hitting at least one 215% stock are extremely strong.

Third, you have to avoid doing the one thing that is almost guaranteed to reduce your expected returns to average or below average. What is that? The answer is "anything (other than reinvesting dividends)." Rebalancing, for example, is certain to reduce the returns on whichever stock is under the winning cup, and the more often you rebalance, the more winnings will siphon off from the winning cup and into the financial black hole (or holes) that exists (or exist) under the losing cup (or cups). The rule for winning the 100 upside cup game is easily restated thusly: Do not press "Sell".

The ability to literally do nothing is why retail investors like us have an inherent advantage over any mutual fund or ETF that exists today - including the absolute most passive of passive index funds like the Vanguard Total Stock Market ETF (VT) and the Vanguard Total Stock Market ETF (VTI) - comprised only of US stocks. According to Morningstar, VT has portfolio turnover of 9%, while VTI has portfolio turnover of 3%.

These funds are purpose built to deliver average returns, but it's like they are running a sack race while you're sporting the latest high-tech Nike running shoes. These funds are respectively handicapped by an extra 9% and 3% chance of potentially pruning winners, allocating into losers, and sloshing capital meaningless from one average-performing stock to another. The retail investor faces no such handicap, and need only remain slightly more lazy than greedy. Her greatest challenge is that it takes less energy to act than it takes discipline to do nothing.

For my part, I don't actually believe that investing needs to be a game of statistics in a cup. Or, if I believe it, I certainly don't behave accordingly. To the contrary, I like to sell high-priced stocks in high-quality companies and buy low-priced stocks in equally high-quality companies. But I am mindful of the fact that every time I click the Sell button, I am increasing the odds that I will diminish my portfolio performance. And perhaps that is exactly why many (most?) active investors - retail and professional alike - tend to underperform the average returns of the overall market. They are clicking "Sell" too often.

Not that what other investors do or don't do is in the least bit relevant to you. You are plainly capable of making a different choice, and as long as that choice involves diversification and doesn't involve much selling, it seems to me that the game may be rigged heavily in your favor, and not otherwise.

Analyst’s 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.

This is not investment advice and I am not an investment advisor. Nothing in this article can be relied upon by any person for any reason other than pure entertainment value.