"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.?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...
Benjamin Graham: On the contrary, the typical investor has a great advantage over the large institutions." - 1976 Interview with Benjamin Graham
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.
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.
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