There are a lot of differences between hedge funds and individual investors. These differences provide some unique benefits and drawbacks for each side.
For example, hedge funds may have limitations on where they can invest. Their size may also prevent them from investing in smaller companies. This is one significant drawback Warren Buffett has always highlighted with Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial).
Indeed, he has said that the conglomerate's size is holding back its returns on several occasions, and he could generate much higher returns in the stock market if he were managing less money.
On the other hand, large hedge funds, in particular, can access assets that are not available to smaller investors. This may allow them to generate higher returns in the right environment. But, this advantage may be squashed by the short-term nature of hedge funds.
Most funds have to work hard to keep their investors on side. If they don't, they lose capital, which may force them to sell their investments at the wrong time. Meanwhile, private investors can commit to investing in securities for decades without having to worry about appeasing investors and matching the market.
This is another advantage of Berkshire, and it's one reason why many high-profile hedge fund managers have decided to quit the business and manage their own money instead in recent years.
The overworked investors
A significant challenge individual investors face is the workload. This factor is often overlooked, but it shouldn't be. Most hedge funds are not one-person operations. They will have analysts to find stocks, traders to place orders, managers to manage staff, back-office staff to process paperwork and risk management staff. Then there will be the head of the organization who will decide which direction the business should take.
The average investor has to do all of this work themselves. This means analyzing stocks, assessing risk, managing asset allocation and other general personal finance tasks.
Granted, most investors won't be dealing with the same volume of money as most hedge funds, but that doesn't make the tasks any less important. An overworked investor is no good to anyone, and neither is an investor who spends so much time analyzing stocks that they fail to take into account asset allocation.
Know what you're good at
The thing is, some investors are much better at finding stocks than they are at managing portfolios. It's essential to understand which camp you fall into. Only then can you plan effectively.
In 2008, at a conference for the TIFF Education Foundation, Seth Klarman (Trades, Portfolio) explained why this should be an essential consideration for investors. At the time, he was discussing the challenges of running a hedge fund, but his comments are just as crucial for the average investor:
"One of the things that's vastly different from being an analyst to running your own fund — and I can't emphasize this enough — is that they comprise incredibly different skills. The inability to think about risk the right way may not matter at all for an analyst. We're not asking for their judgment on risk, we're asking for analysis and facts, and then secondarily, their opinion. It's the portfolio manager who eventually needs to be able to identify risk, whether it's an excessive concentration, a failure to diversify, a failure to hedge, or a failure to understand the risk that is sitting right on your shoulders and you don't realize it. Failure to recognize those things can kill people."
Investors need to understand which camp they fall into. It is fine to understand security analysis but not asset allocation. It is equally fine to understand asset allocation but not individual security analysis. The trick is to know and understand your strengths and then play to those strengths rather than trying to be something you're not.
Disclosure: The author owns shares in Berkshire Hathaway.
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