Individual investors, in aggregate, do not do terribly well in the stock market. Institutions, meanwhile, tend to do much better. Yet, while this has persistently been the case across time and geography, it does not mean individuals are fated to lackluster performance.
If individuals can develop a thorough understanding of whence institutions’ performance edge emerges, they can gain the same superior returns, while avoiding falling into the traps that so often snare their compatriots.
The little guy keeps losing
The underperformance of individual investors is well documented. Professors Brad M. Barber and Terrance Odean of the University of California have explored the subject at length. In a case study of Taiwan’s stock market, Barber and Odean found that individual investors lost consistently, while institutions tended to beat the market:
“Individual investor trading results in systematic and economically large losses. Using a complete trading history of all investors in Taiwan, we document that the aggregate portfolio of individuals suffers an annual performance penalty of 3.8 percentage points. Individual investor losses are equivalent to 2.2% of Taiwan’s gross domestic product or 2.8% of the total personal income. Virtually all individual trading losses can be traced to their aggressive orders. In contrast, institutions enjoy an annual performance boost of 1.5 percentage points, and both the aggressive and passive trades of institutions are profitable.”
Barber and Odean have pursued this puzzle further, exploring the comparative performance of individuals and institutions across numerous geographies. Their more recent paper, “The Behavior of Individual Investors,” offers a far broader conclusion in terms of individual investor performance:
“The evidence indicates that the average individual investor underperforms the market -- both before and after fees.”
The evidence clearly shows that, as a group, individual investors fare rather poorly in terms of stock performance. But why is this the case?
A matter of skill and info
Asymmetries of information and investment skill are perhaps the biggest reason that individual investors suffer while institutions prosper. Michael Mauboussin of BlueMountain Capital Management presented a compelling analogy to describe this asymmetry between the institution and the individual:
“The game of tennis provides an analogy for understanding analytical skill. Imagine a match between a tennis professional and a weekend warrior. They use the same equipment, play on the same court, and abide by the same rules. But the professional will have a better technique and strategy and will be prone to fewer errors. In the world of investing, institutions are the professionals and individuals are the weekend warriors.”
Independent investors must understand that, despite the appearance of parity in terms of tools and access to markets, institutions by their very nature are more broadly and deeply interconnected into the financial system. Thus, they have access to more information than most individuals could hope to obtain. They can also dedicate individuals within their organizations to focus on specific skill-sets and knowledge bases, something a single human mind cannot do.
Exploiting individuals for fun and profit
All excess returns, both positive and negative, must net out to zero. If they do not do so, then something is wrong with the financial model in question. After all, an excess positive return must be zeroed out by some excess negative return if the market return is to have any meaning.
This is not merely an academic point. Indeed, as Mauboussin has pointed out, institutions can achieve excess positive returns by exploiting the strategic and tactical inefficiencies endemic in the body of individual investors:
“Institutional investors generally beat individual investors when they go head-to-head, which means that individuals can be a good source of excess returns for institutions ... Institutions generally have better information and analytical skills than individuals do.”
There are numerous examples of institutional investors achieving excess returns at the expense of individual investors. Initial public offerings offer a particularly stark example, thanks to a groundbreaking 2009 study showing that institutional investors’ stronger performance with IPO trades was due to more than the possession of private information alone:
“Newly public firms with the highest levels of institutional investment significantly outperform those with the lowest levels. While prior literature has attributed much of institutions’ higher returns around various corporate events to private information, we find that much of the difference simply reflects better interpretation of readily available public information. Individuals disproportionately invest in the types of firms that earn significantly lower abnormal returns over the long run. Individuals either disregard or misinterpret the relevance of readily available public information, and as a result, they bear the brunt of IPO underperformance.”
Institutions win because they make better decisions based on better analysis of available information. That is their strategic edge over the great mass of individual market participants.
What you can do about it
Now that we know the problem exists, we can work to correct it. Or rather, we can learn to avoid falling into the traps that have long dogged individual stock operators.
The first step is to stop thinking like an individual. That means working to overcome the natural psychological biases and blind-spots that infect every person. A team can identify and work through such analytical inefficiencies, but they can go unnoticed by an individual.
Individual investors are lone wolves by nature much of the time. But, if they want to survive in this increasingly harsh market world, they must accept that a pack can offer certain benefits. Sharing resources, knowledge, and experience can help make individual investors better, without ceasing to be independent operators.
The path of the individual investor is fraught with difficulties, but the rewards can be great. As a small family office, we are confronted with many of these issues in much the same way a lone operator would be. Perseverance and deep commitment to analytical improvement are essential pillars to successful investing. Institutions can afford to be lazy on occasion. Individual operators lack that luxury.
No individual is likely to be able to muster the resources, contacts or access to knowledge depth available to any institutional investor of appreciable size. These represent challenges, to be sure, but they are not insurmountable.
Disclosure: No positions.
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