For those not very familiar with investing it is natural to assume that an amateur private investor must be at a big disadvantage to the professionals. After all, stock-picking is a zero sum game. Surely it must be difficult to win at this game at the expense of the people who do it for a living. These people have greater knowledge and expertise, have spent much more time honing their skills and benefit from better access to information and to company management.
In previous times, greater access to information used to be a huge advantage for the professional investor, but more recently this advantage has been eroded. Private investors now have all the important information they need at their fingertips through various services provided on the internet. The value of the additional detailed information, analysis and access to company management that professionals do still benefit from has severely diminishing returns.
In fact, private investors actually now have some fairly major advantages over the professionals. Due to the smaller size of our portfolios, we face much better market liquidity, allowing us to quickly buy or sell significant positions without affecting the market price. We do not face constraints in the type of asset we want to hold and can choose to hold cash rather than remain fully invested whenever this seems appropriate. We can make decisions to buy or sell in an instant, without needing approval from any governance. We do not face the same social pressures as professionals – our reputation is not at stake and so we do not have to care so much about ‘being right’ or not looking like a fool if a mistake has been made.
If exploited well, these advantages should mean that the private investor has a huge edge. However, exploiting them well is easier said than done. And most of what I have read about how private investors should take advantage doesn’t really seem to make much sense.
The consensus seems to be that a private investor should have greater conviction to go against the herd and hold on to their favoured investments through thick and thin. While professional fund managers are under pressure to constantly chase short term outperformance, a private investor can benefit from more long term thinking and having the conviction to hold through periods of underperformance.
Thinking long term when selecting investments is very sensible and I believe is one of the ways that any investor, professional or amateur, can outperform the often myopic market. However, having a long term perspective does not necessarily imply holding with great conviction through thick and thin. More to the point, this idea doesn’t really relate to the advantages of a private investor over a professional one.
All investors feel pressure from temporary underperformance. The fact is that the underperformance may not be temporary – indeed, statistically speaking underperformance generally begets more underperformance – the momentum effect. It is inherently challenging to know how much conviction one should have. Sure, remaining emotionally detached and resisting short term urges is important, but it is not clear that private investors have the advantage here. While they may face less external pressure, private investors have less experience and their own money on the line.
I’m also a bit sceptical as to how much pressure there is on professionals not to buy and hold, given that this is the conventional wisdom. I would have thought the pressure was more likely to be for them to trade less and that facing less liquidity would restrict them from trading too quickly anyhow. I suspect portfolio turnover for the professionals is much lower than for amateurs on average.
If you think about it, illiquidity and the social pressure not to make (or admit to) mistakes and layers of decision-making bureaucracy are essentially additional costs to trading that are faced by professionals but not by amateurs. These additional costs should deter or slow down professionals from action rather than cause them to do too much. For example, put yourself in the shoes of a fund manager who has recently invested in a new position only to have it issue an unexpected profit warning. There is likely to be social pressure to stick to your guns rather than admit your mistake, sell out again and look like a mug. You may not even have a choice in the matter if the share is too illiquid to sell out of your position. Similarly, a professional may find it more difficult to change his mind about a share he was previously bearish on or respond opportunistically to sudden good news.
These costs make it take longer for prices to respond efficiently to news and may contribute in part to the momentum effect. They affect both professionals and amateurs, but professionals to a much greater extent as the social pressures and liquidity issues are greater. In my view, the logical consequence is that compared to professional the PI should be better able to:
- respond more quickly to mistakes or profit warnings
- exploit momentum through running winners and selling losers
- run a more concentrated portfolio but with lower risk/conviction as shares can be sold quickly if something goes wrong
- focus more on smaller cap stocks
The relative weakness of professional investors is that they are pressured to have excessive rather than insufficient conviction in the face of great uncertainty. Private investors have an advantage precisely because we need less conviction than a professional, allowing us to be more objective and more agile.