Does the professional investor, FII or the institutional investor have a big advantage over the small, part time investor?
Fact 1: The professional investor has access to in-depth research on a large number of companies. They also have access to the management and other industry professionals which allows them to cover an industry in depth and finally they do this on a full time basis. How can you beat that?
Fact 2: Very few mutual funds and institutional investors are able to beat the market over the long term (5+ years). In case of developed market such as the US where the performance numbers are more readily available (including those of hedge funds), only a handful can beat the market by a few % points.
How does one explain these two contradictory facts?
There are several reasons for this contradiction and I will explore some to highlight how a small investor like you and me can still score over the big boys.
The over emphasis on industry knowledge
The number one advantage cited is that the professional has access to in-depth analysis of an industry and can thus make better decisions. I think this advantage is overrated.
As an individual investor, if one really wants to learn about an industry, a good starting point is to read the annual reports of the top 3-4 companies in the industry. In addition there is a wealth of information available on the internet which one can Google to explore an industry in depth.
In the pre-internet days, the professional investor had substantial advantage over the part time investor but now a lot of information is available at the click of a button.
The other point cited by those trying to sell you funds and other such products is they have access to the latest data on the industry. I don’t think this is a big advantage to a long term investor. If your time horizon is 3-4 years, then getting the monthly sales figures before everyone else is hardly of any advantage unless you want to trade on that information.
Professional behavior
The other advantage of the professional investors is assumed to be their experience and ability to act more rationally than the small investor. I have not seen any evidence which shows that the professionals are more rational than the rest of the market.
Several fund managers and FIIs have portfolio turnovers in excess of 100%, which means that these professionals have an average holding period of less than 1 year. In addition if you look at the FII behavior, they demonstrate the classic herd behavior – exit the market when everyone is doing so and re-enter when the market starts picking up or has already risen substantially.
The net effect of constant turnover and herd behavior is higher cost (transaction costs) and lower returns over the long term.
As an individual investor, I do not have the pressure to follow others or excessively churn my portfolio. I can afford to hold a stock for 5 years, if the long term outlook for the company is bright even if the short term price performance is expected to be terrible
The institutional pressures
The point which is never highlighted by brokers and professionals is the problem of institutional pressures. Professional managers live by the quarter – though they ask their customers (investors) to think long term.
Any fund manager who under performs the market for a few quarters is at the risk of losing his or her job as the fund management company faces the risk of losing the assets due to redemptions. In addition, even if the fund manager is rational and long term oriented, they cannot afford to take unpopular decisions such as buying capital goods or financial stocks now as any underperformance due to such stocks will result in a career suicide.
This institutional pressure more or less forces the fund manager to buy the popular stocks and mimic the index with minor variations in the long run.
The small investor like you and me has none of these compulsions. In my case, other than the risk of looking foolish (sometimes publicly or worse in front of my wife) in the short term, I don’t face the risk of losing my job or ruining my career due to any unconventional decisions. This is a big advantage over the big boys
Is there any disadvantage?
The key assumption in my arguments till now is that the small investor is willing and able to devote a reasonable amount of time in researching companies and following up on them. There is no short cut for that.
Can you think of any time in college where you did not attend any classes or even study a new subject on your own and still managed to do very well in the final exam (without cheating of course )?
I personally think that if you are interested in investing and willing to devote 5-6 hours a week consistently on it for a long time, there is no disadvantage of information or insight versus the professional. On the contrary as a small investor, one does not face the institutional pressure and thus has an advantage over the professional.
Rohit, how do I access the google groups links mentioned in your past posts.
One of the big advantage of being part time investor is that one is not exposed or watching stock gyrations day in and day out; which prompts person to do something -“All men's miseries derive from not being able to sit in a quiet room alone.” — Blaise Pascal
Another thing:The entry and exit costs for a MF are higher due to volumes. As a small investor, i can buy and exit without anyone [ barring the taxman] noticing.Also, As Peter Lynch, the common investor can invest *ahead* of the professionals, if he keeps his eyes and ears open. Whereas, MFs can and only do buy, when it is Kosher to do so, i.e. enough other funds are tracking. Regards,Arun
Hi Rohan,Excellent topic. I am sure a lot of investors are disgruntled by the posturing done by Mutual funds and the kind of service, poor performance and in a lot of cases losses suffered by the lay investor.One of the messages touted by mutual fund purveyors is that in India, Mutual funds outperform Index funds..and therefore one should invest long term or SIP mutual funds. What is your take on that?Best, Vidyanshu.
Hi Rohit,I think you should mention 'Value Investor' (who may be a small investor) Vs a generic 'Small Investor'. A typical small investor gets interested in the market when its high and lose the interest when its down like now. They in turn lose money.A lot of professional investors are linked with brokerage houses and have compulsion of giving 'Buy' or 'Sell' recommendation. There is no brokerage for holding a stock for long term. So, they don't recommend that.I doubt if they follow the same sets of transactions / portfolio when they invest their own money Vs manage somebody else's money thru a mutual fund etc.Thanks,
Great article again Rohit. I find your writings much better then other columns by professionals in financial papers. Simple, interesting and really giving knowledge. Am a starter into investing though been on-off the market for years. Have started reading The Intelligent Investor and AR of companies am interested in and gaining knowledge with each day.Thanks again,Vishv
Totally agree. If we could just keep our emotions under control AND put in a bit of consistent effort, it is very easy to beat the market by 2-3% (which essentially means beating 80% of the “professionals”).
Very interesting thoughts!Another important factor is the amount of money under management.Professional investors simply have a much smaller investment universe, because it doesn't make much sense to invest in a stock, if you can't buy a sizable amount in relation to your overall portfolio.Because of that, very small companies are often underfollowed, which can result in nice opportunities for part time investors.
Hi hemantthe google group has been closed by google. i will upload the files at a differen location soonrgdsrohit
Hi manishyes..you are absolutely right. pascal's quote comes to mind often ..not watching cnbc and other channels round the clock is sometimes quite helpfulrgdsrohit
Hi arunwe have a lot of advnatges over MF …being long term oriented, buying micro caps, buying good stocks over 5% limit of portfolio and others. finally we can be more sensible than the average MF fund managerrgdsrohit
Hi vidyanshuyes there are some MFs which do manage to beat the index …but very few. if one can concentrate on those then it is not a bad idea to invest.however the same MF are also selling other garbage like sector funds, fund of funds etc. so in a way you have to be knowledgable enough to sell a decent fundi have invested in some funds for quite some time like HDFC equity fund and they are good.rgdsrohit
Hi anonwhat you mention is basically is the incentive caused bias…what makes sense for the business does not make sense for the customer. churn or constant buy/sell makes money for brokerage but works against the investor.the above problem is one more problem for the investor when investing through 'professional'in the end the ignorant small investor gets really horrible advice. my own family in the past has got very bad advise (when i was growing up)rgdsrohit
Hi vishvthanks for the comment. intellignet investor, letter to shareholders from warren buffett and other such books/ articles is a good point to start. that and AR of company's is good enough to make you a knowledgable investor and should help in making good decisionsrgdsrohit
Hi luckythats the key – emotions. look at how many people were scared to buying anything in the last 3 months because the world was coming to an endrgdsrohit
Thanks Rohit for another good article.Knowing you, I'm sure you can still follow these principles even if you pursued Investing Full time.:-)Vikas