David v Goliath
How private investors can beat institutional investors...
Before you continue, I just want to thank all of you for your support. We all start somewhere, and every reader is well appreciated!
Institutional investors have many advantages over us, private investors. To name but a few:
economies of scale (i.e. lower costs)
access to advanced screening & research tools
quality and recency of information
access to more financial instruments, etc, etc.
But there are advantages we have that they don’t, and I believe they can be decisive. Here are my top tips.
1. Exploit low coverage areas
When you are a mouse, you can feast on crumbs. For most of us, our investing pot is orders of magnitude smaller than that of your run of the mill asset manager, hedge fund, pension fund, or any other institution. This means that there are many investments where it is not economical for institutions to even consider them (e.g. small cap stocks, stocks with small % float, or otherwise low liquidity). In other words, your investment universe is bigger (in places). So search every corner.
2. Use a long-term mindset
Many of the weaknesses of institutional investors come from agency costs*, and one of the most critical one involves the incentives around short-termism. Whether it is acknowledged or not, investment professionals are under great pressure to produce strong performance in the short run, because they will be judged on it. This means they may well pass-up on investments that might take a long-time to come to fruition, and this provides opportunity for the patient investor to exploit without fear of judgement over short-term performance.
*An agency cost is an economic concept that refers to the costs associated with the relationship between a "principal", and an "agent". The agent is given powers to make decisions on behalf of the principal. However, the two parties may have different incentives and the agent generally has more information.
3. Don't be afraid of risk or contrarianism, but don’t seek them out
Linked to the previous point, investment professionals are, I believe, particularly prone to group-think and loss aversion. The ultimate goal of an investment professional is to keep their job, and the reality is that the negative consequences these individual will face for being wrong far outweigh the positive consequences for being right.
Moreover cutting against the grain, and recommending potentially risky investments that are out of favour in the mainstream, even when the average outcome may be good, is not a rational decision for an investment professional. If you are right, you're doing your job, if you're wrong, you just look stupid. It's far safer to be wrong as part of a collective. As the ancient saying goes, nobody gets fired for buying IBM.
For the individual investor however, generating alpha is all that should matter, and being able to seek out contrarian ideas without fear of disrepute is a real advantage. The flip side of this must also be acknowledged. Just because an opportunity is contrarian and/or risky, it doesn’t make it a good one.
4. Be patient but fickle
Many investment professionals & institutions build careers/niches in particular sectors or geographies. The reality is that particular sectors or geographies offer greater or lesser investment opportunity at different times, and these funds and individuals do not have the optionality to pick and choose when the time is right. I can't imagine Cathie Wood abandoning high growth tech stocks in any eventuality, can you? Private investors can use their agility to bounce between sectors and regions when the time is right.
Moreover, it is more difficult for institutions to admit they're wrong, or to turn their back on an investment thesis. Again, there is more that just pride, but reputation, that is at stake for them. It is important for private investors to be patient with their investments, but the moment the facts change, be fickle and be ruthless.
5. Trust your judgement
Some may also argue that, as professionals, institutions also have a technical or intellectual edge over private investors. Whilst we, as alpha seeking investors, must rely on the flaws of the average investor in order to convince ourselves that we can beat the market, I have met enough professionals in my life to know that investing isn't rocket science, and that they are as human as the rest of us, if not worse.
Have any more to add? Let me know!
Thanks for reading.
Eddie