Does the professional investor, FII or the institutional investor have a big advantage over the small, part time investor?
Fact 1: The professional investor has access to in-depth research on a large number of companies. They also have access to the management and other industry professionals which allows them to cover an industry in depth and finally they do this on a full time basis. How can you beat that?
Fact 2: Very few mutual funds and institutional investors are able to beat the market over the long term (5+ years). In case of developed market such as the US where the performance numbers are more readily available (including those of hedge funds), only a handful can beat the market by a few % points.
How does one explain these two contradictory facts?
There are several reasons for this contradiction and I will explore some to highlight how a small investor like you and me can still score over the big boys.
The over emphasis on industry knowledge
The number one advantage cited is that the professional has access to in-depth analysis of an industry and can thus make better decisions. I think this advantage is overrated.
As an individual investor, if one really wants to learn about an industry, a good starting point is to read the annual reports of the top 3-4 companies in the industry. In addition there is a wealth of information available on the internet which one can Google to explore an industry in depth.
In the pre-internet days, the professional investor had substantial advantage over the part time investor but now a lot of information is available at the click of a button.
The other point cited by those trying to sell you funds and other such products is they have access to the latest data on the industry. I don’t think this is a big advantage to a long term investor. If your time horizon is 3-4 years, then getting the monthly sales figures before everyone else is hardly of any advantage unless you want to trade on that information.
The other advantage of the professional investors is assumed to be their experience and ability to act more rationally than the small investor. I have not seen any evidence which shows that the professionals are more rational than the rest of the market.
Several fund managers and FIIs have portfolio turnovers in excess of 100%, which means that these professionals have an average holding period of less than 1 year. In addition if you look at the FII behavior, they demonstrate the classic herd behavior – exit the market when everyone is doing so and re-enter when the market starts picking up or has already risen substantially.
The net effect of constant turnover and herd behavior is higher cost (transaction costs) and lower returns over the long term.
As an individual investor, I do not have the pressure to follow others or excessively churn my portfolio. I can afford to hold a stock for 5 years, if the long term outlook for the company is bright even if the short term price performance is expected to be terrible
The institutional pressures
The point which is never highlighted by brokers and professionals is the problem of institutional pressures. Professional managers live by the quarter – though they ask their customers (investors) to think long term.
Any fund manager who under performs the market for a few quarters is at the risk of losing his or her job as the fund management company faces the risk of losing the assets due to redemptions. In addition, even if the fund manager is rational and long term oriented, they cannot afford to take unpopular decisions such as buying capital goods or financial stocks now as any underperformance due to such stocks will result in a career suicide.
This institutional pressure more or less forces the fund manager to buy the popular stocks and mimic the index with minor variations in the long run.
The small investor like you and me has none of these compulsions. In my case, other than the risk of looking foolish (sometimes publicly or worse in front of my wife) in the short term, I don’t face the risk of losing my job or ruining my career due to any unconventional decisions. This is a big advantage over the big boys
Is there any disadvantage?
The key assumption in my arguments till now is that the small investor is willing and able to devote a reasonable amount of time in researching companies and following up on them. There is no short cut for that.
Can you think of any time in college where you did not attend any classes or even study a new subject on your own and still managed to do very well in the final exam (without cheating of course )?
I personally think that if you are interested in investing and willing to devote 5-6 hours a week consistently on it for a long time, there is no disadvantage of information or insight versus the professional. On the contrary as a small investor, one does not face the institutional pressure and thus has an advantage over the professional.