Sunday, December 15, 2013

Exploit Your Advantages as an Individual Investor

"Charles Ellis: Turning now to individual investors, do you think that they are at a disadvantage compared with the institutions, because of the latter's huge resources, superior facilities for obtaining information, etc.?

Benjamin Graham: On the contrary, the typical investor has a great advantage over the large institutions." - 1976 Interview with Benjamin Graham
Every so often, particularly after I've made an error in judgement, I consider selling my individual stocks and going 100% into index funds. Just think of all the time I'd save not researching on the weekend...

Eventually I come to my senses and remember that any extra time saved would probably be spent on a golf course, growing increasingly frustrated by a series of 200 yard slices into the woods and three-putts. But I digress.

Invest long enough and doubt inevitably creeps in. Frankly, I'd be concerned if you didn't doubt yourself now and then. Overconfidence is not a long-term asset in the investing world.

You're going to make some mistakes along the way, but the key is to make mistakes while exploiting your advantages as an individual investor. As Charles Ellis noted in his question to Ben Graham, institutions have a number of advantages over individuals, so there's little point to going toe-to-toe with them on their home turf. Instead, focus on areas where you, the individual investor, have natural advantages.

Patience and independence

The first advantage is really what this blog is dedicated to: the individual investor's ability to be patient and think long-term.

Institutional investing is very much a "What have you done for me lately?" business and fund managers are frequently compared with the performance of their peers and their benchmark. Your fund could generate 50% returns in a year, but if your peer group generated 60% returns, brace yourself for cash outflows.

In fact, a recent study on Warren Buffett's track record found that his ability to survive extended periods of market underperformance -- due to his reputation and unique operating structure as a corporation -- played a key role in his results. Most institutional investors don't enjoy similar advantages and are thus required to focus on short-term results while not deviating too far (on the downside) from the peer group.

Individual investors, on the other hand, don't have to worry about underperforming in a given year and can thus maintain a patient and long-term focus. You can hold a large cash position or take a contrarian position, for instance, and give your thesis a few years to play out without worrying about investors pulling money out of your fund.

Making meaningful investments in smaller companies

In the 1995 Berkshire Hathaway letter, Buffett wrote: "The giant disadvantage we face is size: In the early years, we only needed good ideas, but now we need good big ideas." In order to have a meaningful impact on results, institutional investors with hundreds of millions under management need to make large investments. As assets under management increase, fund managers find it difficult to make large investments in small companies without dramatically increasing the share price or taking an unwanted controlling stake in the company.

As a result, institutional investors are forced buy a lot of small stakes in small companies or focus on large companies. In either case, their opportunity to consistently generate high compounding growth rates is more limited than it is for individual investors who can take meaningful positions in promising smaller companies.

Given the advantage of having less capital, individual investors -- even those favoring dividend-paying stocks -- shouldn't be afraid to look for small cap opportunities that fit your normal investing criteria.

The ability to think like business owners

The short-term performance pressures on institutional investors also limits their interest in taking the perspective of a business owner in the stocks they are buying. If you're going to sell the stock in a few weeks or months, why bother worrying about management's incentives? (Indeed, Vanguard founder Jack Bogle has called this out as one of the reasons for a declining sense of corporate governance and responsibility, but that's a separate topic.)

Conversely, with no such performance pressures, individuals can invest in companies in which they'd like to take a long-term, business-focused position. This requires a differentiated research process -- one that focuses on things like the company's durable competitive advantages, management's capital allocation skill, and the board's dividend policy.

Bottom line

Though it may not always be apparent, individual investors have a number of advantages over institutional investors. Mistakes and frustrations are a part of investing, but if you're going to err, err while pursuing these advantages -- namely, the ability to be patient and independent, invest in a wider universe of stocks, and take the perspective of a business owner.

This will be the last Clear Eyes Investing post in 2013 and I just wanted to say "thank you" for reading this year. The blog eclipsed 50,000 page views earlier this month, which is about 50,000 more than I ever expected when I started writing last year. I particularly appreciate the frequent references from your own blogs and those of you who've shared my posts via email and social media. 

Merry Christmas and a Happy New Year! 


Good reads this week:

  • Warren Buffett's meeting with University of Maryland MBA students - Dr. David Kass
  • What history tells us about investing in dividend income stocks - Investment Moats
  • Why closet index trackers need to be relegated out of existence - UK Value Investor via Stockopedia

Quote of the week:
There is a set of advantages that have to do with material resources, and then there is a set that have to do with the absence of material resources -- and the reason underdogs win as often as they do is that the latter is sometimes every bit the equal of the former. - Malcolm Gladwell, David and Goliath

Saturday, December 7, 2013

Nothing Should be More Important to Investors

"Ultimately, nothing should be more important to investors than the ability to sleep soundly at night." - Seth Klarman  
In a recent post about becoming a more patient investor, one of the tips I shared was to stay reasonably diversified because having a highly-concentrated portfolio would likely keep you up at night and lead to impatient trading decisions.

Upon further reflection, this advice was a bit off the mark as it was specific to my own investing personality and isn't a universal law. For other investors, a highly-concentrated portfolio of thoroughly-researched investments may provide them more than enough comfort, while others may only feel comfortable in broadly-diversified index funds.

Homer gets it
Each investor's risk-taking personality is different -- it could be in our genes -- but the key is to invest in a manner that lets you sleep at night without worrying what the next trading day, week, or month might bring.

At the core of this discussion is anxiety produced by our investment decisions. Losing sleep may be a consequence of the anxiety -- it can also manifest itself in nail biting, smoking, pacing, or at worst, panic attacks -- but it's the root cause of what we need to avoid as patient investors.

When we're anxious as investors, we're not acting as investors at all -- we're simply speculating and we're much more prone to making destructive short-term decisions.

Thinking about it this week, I see five main causes for undue investment-related anxiety:

  1. Investing outside of your core competency: Remember Peter Lynch's principle #5: "Never invest in any idea that you can't illustrate with a crayon." If you don't understand the business, you're more likely to become overly concerned about temporary issues or not concerned enough about long-term issues. 
  2. Not doing your own research: Whether you're getting investment ideas from a friend, newsletter, or financial website, it's important to look into the company yourself and decide whether or not you agree with the idea. There are pretty good odds you're not going to miss the opportunity if you wait 24 hours after hearing the idea to do your own research. 
  3. Employing unsuitable amounts of leverage: For the individual investor, leverage most often comes in the form of margin borrowing or options strategies. While both of these tools in themselves are not bad, they can serve to magnify both gains and losses and should be used with caution. 
  4. Being a forced buyer or seller: One advantage of being an individual investor is that we typically don't need to be forced buyers or sellers as we don't have clients giving and taking money to and from our funds on a regular basis. Still, we can fall victim to being a forced trader when inappropriately using leverage or investing short-term money in long-term assets.
  5. Reaching for return: In The Most Important Thing, Howard Marks recalls, "It's remarkable how many leading competitors from our early years are no longer leading competitors (or competitors at all). While a number faltered because of flaws in their organization or business model, others disappeared because they insisted on pursuing high returns in low-return environments." This a particularly important point to remember in today's market and dividend investors, for example, who are reaching for ultra high yields (more than 2.5x the market average) are exposing themselves to ultra high risks

Why aren't market movements one of the causes of anxiety? Don't get me wrong, I don't enjoy seeing my portfolio lose money any more than the next person, but if we truly are patient long-term investors and can avoid subjecting ourselves to the five root causes of investment-related anxiety, short-term fluctuations shouldn't result in unmanageable levels of anxiety. In fact, we can even use Mr. Market's anxiety to our advantage by being prepared to buy when he's despondent and sell when he's euphoric.

There are countless investment quotes and sayings worth keeping in mind, but the Klarman quote at the beginning of this post is one of the dozen or so that's worth worth writing down and keeping near your desk. It's a good reminder to always invest in a manner that lets you avoid high levels anxiety as it will allow you to stick to your strategy regardless of what the market is doing in the short-term.

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Good reads this week:

Quote of the week: 
"As a rule," said Holmes, "the more bizarre a thing is the less mysterious it proves to be." - Sir Arthur Conan Doyle