The passive segment of the asset management industry has done a great job of convincing everyone that active management is suboptimal, and I’d say the vast majority of people should abstain from trying to actively manage their own holdings.
However, there are several issues with the blanket assumption that no one, or very few, can outperform the market because the vast majority of professional managers fail to do so. Those issues pertain to the constraints faced by professional managers that are not necessarily faced by those managing smaller amounts of money.
Before delving into those issues, however, it should be said that if you are unable to value a company and understand its financial statements (including the footnotes), you shouldn’t invest in individual stocks. Better to devote time to other areas of life and enjoy the average returns offered by indexing.
Those who can assess valuation, however, and are “blessed” with having a smaller amount of money to invest have some powerful advantages over professional managers. First, the universe of available investments is far, far larger. Most professional managers have a limited universe of investable securities because they cannot deploy enough capital in smaller issues without severely damaging the liquidity of that stock, but more importantly, they can’t deploy enough money to make it worth their while. The larger number of informed investors looking at a finite universe of stocks will make it relatively more efficient than a group of stocks that are not pored over by professional analysts. Hunt where there are game and where relatively few expert hunters are able to go.
Second, professional fund managers generally must adhere to diversification rules forcing them to invest in far more stocks than necessary or desirable to achieve a prudent level of risk mitigation. That means they must make far more decisions, and more decisions equals fewer good decisions. In essence, investing can be like poker. Most of the time, do nothing, until a high probability hand drops in your lap. Then, you must take advantage and not simply invest 2% of your funds. Professional fund managers (and I’m speaking mostly of mutual funds, but also larger hedge funds) can’t do that.
Third, volatility kills asset management businesses. Large moves down can lead to withdrawals, which equals less AUM to earn management fees upon. The reality is outperformance over longer periods necessarily means larger price volatility, since a portfolio with fewer but higher conviction investments tends to move more than a more diverse portfolio that looks like an index. If you want a result that is better than average, you must do something that is different than the averages. In my view, this requires an unusual amount of emotional stability and is probably the greatest reason why many individual investors are unable to outperform.
Summed up, an investor with a comparatively small amount of capital without the demands of the asset management business has access to a broader array of investments and does not have to make as many correct decisions, which are basically predictions about the future, to do better than average. This assumes this person can assess a business and value it conservatively. Following those tools can take a small pool of money and make it large, where you would start to face the constraints borne by larger fund managers. But by then, you’d be rich, so who cares?
www.morningstar.com
