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Steven Chen
Steven Chen
Articles (206)  | Author's Website |

The Competitive Advantage of Being an Individual Investor

Why every one of us should have a decent chance of beating Wall Street

Wall Street professionals look brilliant at first sight, thanks to their fancy degrees, glamorous paychecks and expert-like images on TV. However, data consistently demonstrates that over 80% of professional investors struggle with consistently outperforming widely recognized indexes (i.e. the market averages). It is also widely acknowledged that market-beating mutual fund managers are likely to underperform for the near future. So what does this imply for investors of all types, fund managers included)? We need to dig deeper to find the root cause.

Size disadvantage

The investable universe shrinks when the fund size grows. In the end, the money manager would have to deal with a sizeable amount of capital to be deployed over time, while there are just not many attractive businesses with larger market caps. This is a typical case found among many successful fund managers with a proven track record, including Warren Buffett (Trades, Portfolio), whose Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) is “burdened” with over $120 billion in cash that it cannot yet find a good use for.

For investment managers in such a situation, we think that limiting fund size might work better than trying to expand the circle of competence. At the same time, individual investors with smaller sums would not need to bother with this, as they have greater flexibility in terms of picking stocks. To beat Wall Street, they may want to have a bias towards smaller companies and hidden gems (e.g., Armanino Foods of Distinction (AMNF) and Bioventix (LSE:BVXP)) and ignore the headline hypes on media.

Market sentiment

Investors are often their worst enemies. They have proven to be good at buying high and selling low, which applies to average professional investors as well. Meanwhile, even those money managers with superior emotional intelligence can be also impacted by their client behaviors and often find themselves short of cash after the market crashes or oversupplied with incoming funds when the market valuation is getting hefty.

Mr. Buffett once cited the long-term loyal investor base of Berkshire Hathaway as the company’s competitive strength. He also shut down his investment partnership and returned money to his clients during a market bubble previously, where he saw difficulties in finding value due to the dominance of speculation in the market. Unlike professional managers, individual investors have full control over their money. With such an advantage, all they need to ensure is their own objectivity and rationality, understanding that the market is there to serve them not to instruct them. Otherwise, by buying a low-cost index fund, these investors can still find a great chance (i.e., roughly 80%) of beating Wall Street.

Index hugging

If beating the market turns out to secure an only 20% possibility, it is natural for many money managers to “strategize” in the other direction by trying not to be in the bottom half compared to market performance. This is where the index hugging comes into play. As a result, Wall Street professionals tend to over-diversify their portfolios, chase hot concepts and be “short-sighted."

We would highly appreciate it if any asset management firm embeds a long-term time horizon into its KPI system (e.g., a full market cycle at City of London Investment Group (LSE:CLIG)), although we understand the massive challenge of doing so. To outperform the Wall Street crowd, individual investors with an active approach would need to stay focused on building a concentrated portfolio of stocks within their circle of expertise in the long run.

Fee

Last but not least, fees kill performance – by a lot! The average mutual fund charges nearly 1% in the U.S. and a higher rate overseas. If you think the 1% rate is negligible, do the math and see its compounded effect. On the top of the annual management fee is the hidden charge – the trading cost (e.g., commission, tax) due to frequent share dealing. “Return decreases as motion increases.” This is why we recommend an ultra-low-frequency trading strategy as a long-term investor. To beat Wall Street, individual investors should keep investment costs as low as possible or choose to pursue an index approach.

Disclosure: The mention of any stock in this article does not constitute an investment recommendation; investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Berkshire Hathaway, Armanino Foods of Distinction, Bioventix and City of London Investment Group.

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About the author:

Steven Chen
Steven CHEN is a quality-focused, business-perspective investor (with bottom-up opportunistic approaches), an ex-hedge fund analyst on Wall Street, a serial entrepreneur, computer scientist, and free-market capitalist.

Steven is the Managing Partner of Urbem Partnership, a value/quality-focused investment partnership fund (www.urbem.capital).

Steven can be reached at [email protected], LinkedIn, or WeChat (ID: LSCHEN2005).

Also, check out his column at Smartkarma on the Asian market - www.smartkarma.com/profiles/steven-chen

Visit Steven Chen's Website


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