Reblog: The Individual Investor’s Edge

“The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.” — Warren Buffett, 2013 Letter to Berkshire Hathaway shareholders

As Albert Einstein wisely stated, compound interest is the eighth wonder of the world:  He who understands it earns it while he who doesn’t pay it.  The vast majority of individuals who take the initiative to accumulate savings should follow Warren Buffett’s advice on using index funds and dollar cost averaging to achieve satisfactory returns over time.  For those earning at or above the median wage in the United States, it would be very difficult to end up poor if one simply saves ten to fifteen percent of gross income and dollar cost averages into the S&P 500 over several decades.

But what about non-professional individual investors who want to achieve better than average results?  In the short run, the stock market resembles a manic-depressive character who bids up prices one day and sends them down the following day without much of a reason for the change in sentiment.  Benjamin Graham’s “Mr. Market” character perfectly personifies the psychology of financial markets in the short run.

Any individual who pays attention to the markets can observe this insanity and it is seductively easy to draw the logical conclusion:  If the markets are so crazy, why not try to profit from the insanity?

Circle of Competence

“It’s not supposed to be easy. Anyone who finds it easy is stupid.” — Charlie Munger

One of the ironies of financial markets is that while short term action may appear utterly stupid, it is a grave mistake to assume that market participants are individually stupid or that it is somehow easy to outperform market averages by actively trading.  Investors would do well to constantly think about the fact that there is another equally motivated investor on the other side of every trade they are considering.  That investor may resemble Mr. Market’s irrationality at any given time, or he may have superior insights into the security in question.

The existence of superior insight is often referred to having a “circle of competence” encompassing the activities of the business or industry in question.  To claim that an industry falls within one’s circle of competence is not to be taken lightly.  It involves far more than being familiar with a company’s product line or reading about the industry in question in the newspaper.  One must possess expert knowledge of the subject matter to possess superior business insights that other market participants do not also possess.  For most non-professional individual investors, this type of insight is only likely to exist in subject matter related to the investor’s profession.

The problem is that most investors would be ill advised to concentrate their personal investments in their employer or its competitors since there would then be a correlation between the individual’s source of employment income and the performance of his investments.  A general industry downturn could cost the investor his job and, at the worst possible time, result in a severe depreciation in his investment portfolio.  Few individuals, even those with a reasonable emergency fund, would find this correlation of misfortune to be a pleasant experience.

But is it not possible to obtain competence in fields outside one’s area of employment?  It certainly should be with enough intelligence, dedication and effort.  Few individual investors are going to be motivated to spend the time and energy required to truly understand multiple industries, let alone develop special insights that professionals do not have.  It is certainly not impossible for a small percentage of individuals to possess this ability.  However, it would certainly be very difficult for most investors to do so.  On the other hand, it may not be that difficult to obtain a working knowledge of various industries and businesses.  In this case, an individual would possess knowledge that is at least as good as other market participants but perhaps has few, if any, special insights into the industry or business in question. Can such an individual expect to show any meaningful results in exchange for the effort?

Timeframe Arbitrage

The enterprising individual investor has one major advantage that nearly all professional investors lack:  there is absolutely no logical reason to care about short term performance when evaluating investment candidates.  To the extent that commitments to common stocks have a timeframe measured in several years (ideally five to ten years or longer), there is really no reason whatsoever to care about the price movements of the investment over the next week, month, quarter, or year.

The ability to take such a sanguine view of the world is limited to non-existent for the vast majority of professional investors.  Professional investors who are engaged in active management of a portfolio are evaluated based on their performance relative to other active managers as well as benchmark indices.  Professional prestige, career advancement, and compensation hinges on short term performance.  For this reason, many professional investors “closet index” in an attempt to closely replicate the results of a benchmark and deviate from this practice only when they believe that doing so provides an edge in the short run.  The pain of falling far short of a benchmark can be far greater than the pleasure of exceeding it.

It is true that there are many value oriented professional investors who take a longer term perspective.  However, such investors are still not immune to shorter term comparisons.  It is striking how many value oriented hedge fund managers publish quarterly letters to shareholders in which holdings are analysed based on performance over a meaningless timeframe.  Why is this done?  Clearly, investors demand that kind of feedback from managers and it is necessary to comply with this demand in order to retain assets under management.  Even with a long term mindset and the best of intentions, it is hard to see how a value oriented professional investor can make decisions to maximize value in 2020 when he knows that it will be necessary to explain short term price movements a couple of months from now when year-end 2015 results are reported.

Conclusion

Most individual investors are well advised to simply save as much of their income as possible and dollar cost average into one or more low-cost index funds over many decades.  Using this approach, one need not make exceptional amounts of money to retire with a greater net worth than the vast majority of Americans.

With success virtually assured using such an investment approach, one must have very good reasons to deviate and embrace active portfolio management.  Still, many enterprising investors will seek to do better either because they wish to accumulate capital at a faster rate or simply because they enjoy the process (the most successful with having both characteristics).  Such investors will need to develop a working understanding of a number of industries and businesses to have a decent prospect of outperforming a benchmark index over time.

But do they require the truly superior insights implied by the circle of competence concept?

Surely having superior insights is something an investor should aspire to achieve since the truly big winners most likely require such insight.  However, achieving insights that put the individual on par with professionals operating in the same industry could be sufficient if the individual investor harnesses his or her major advantage:  time frame arbitrage.  By doing so, the individual can invest in situations that may appear compelling to a professional in the long run but not in the short run.  The individual will view himself as trading with people who are not stupid but simply have different priorities and goals.

The original article appears on Valuewalk.com and is available here.