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Individual Investors vs. The Market

I frequently make the case that individual investors have little hope of reliably outperforming the market by trying to pick investments on their own. A recent comment on a post from a couple months ago argued that individual investors do have some advantages that might help them reliably outperform the market.

The commenter pointed out that:

  1. Mutual funds are required to stay within a given asset allocation range. Individual investors, on the other hand, can move entirely to cash or entirely to stocks whenever they see it as beneficial.
  2. While each individual trade is a zero sum game in terms of who will come out ahead, some investors aren’t necessarily seeking to come out ahead. That is, “Zero sum games can be beat if everyone is playing for different reasons.” For example, elderly investors might buy dividend stocks simply because that’s what they’re comfortable owning.

Individual Investors vs. Mutual Funds

Regarding the first point, that’s true. Fund managers are not allowed to move entirely into cash whenever they see fit. (Thank goodness!) People have been bringing this up for years. (They usually also point out that fund managers can’t invest more than 5% of the fund’s assets in a given stock, whereas individual investors have the ability to do so.)

Admittedly, these are at least potential advantages to individual investors. The problem is that to be able to exploit these advantages, investors have to be able to:

  • Predict short-term market movements (such that moving into or out of cash would be beneficial), and/or
  • Pick stocks that are likely to outperform the market (such that putting a large portion of one’s portfolio into a given stock would be beneficial).

Every piece of data I’ve seen on the topic indicates that individual investors have little hope of being able to perform either of these feats reliably. And that makes sense; most of us just don’t have the resources.

Individual Investors vs….Other Individual Investors

As to the second point above–the one about zero sum games–again, this one makes sense on a (wonderfully fascinating) theoretical level, but it seems difficult to exploit to one’s advantage.

Even if we assume that there are investors who buy stocks without the intention/hope of beating the market, what percentage of stocks do these investors own? I suspect it’s rather small.

And, more to the point, I’d be willing to bet that these older investors have far lower portfolio turnover than most other market players, meaning that the likelihood of one of these investors being on the other side of any given trade is exceptionally low.

Am I missing something?

What do you think? Is there something I’m leaving out that gives individual investors a meaningful advantage over other market players?

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Comments

  1. Rick Francis says:

    The one area where I think that it may be possible for individual investors to have an edge: very small companies. Mutual Funds or large investors just can’t buy enough of a very small company to make it a significant % of their portfolio without buying controlling interest in the company. If mutual funds aren’t interested in the really small companies then analysts aren’t going to bother following them either. Seems like an inefficient enough market that could reward an individual investor.

    The down side is that individual stocks are pretty risky- especially very small companies. Unless you have a lot of $ transaction fees would be a killer to get a diversified set of companies. I seem to remember reading that E*Trade had a way of buying multiple stocks together into a single purchase so perhaps one could buy 50-100 of the smallest companies that fit some simple filtering criteria and make you own micro-cap-index fund?

    -Rick Francis

  2. Yes, you’re missing something, Mike.

    Individual investors do not have to pick stocks or predict short-term movements to beat the market by large amounts. All that they need to do is to make use of the common sense that fund managers (because they must put marketing first) must rule out of consideration.

    The easy way to beat the market is to go with a higher stock allocation when the price of stocks is low and a lower stock allocation when the price of stocks is insanely high. The historical data shows that this approach (long-term timing, or Valuation-Informed Indexing) has been working for as far back as we have records. It allows the investors who follow it to retire five years sooner than would be possible if they invested passively.

    Fund managers cannot do this. It’s not good marketing to acknowledge that Passive Investing doesn’t work when The Stock-Selling Industry is spending millions promoting it. But individual investors are free to invest according to what common sense says must work and what the historical data shows always has worked. Individual investors have a huge edge over the “professionals” (whose true profession is sales, not stock investing).

    Rob

  3. “Fund managers cannot do this. It’s not good marketing to acknowledge that Passive Investing doesn’t work when The Stock-Selling Industry is spending millions promoting it.”

    In reality at least 90% of funds advertise that their mission is to beat the market and very little is spent promoting passive funds. Why don’t you open your fund that *actually* beats the market since nearly every other fund simply *claims* that it will. :-)

  4. Why don’t you open your fund that *actually* beats the market since nearly every other fund simply *claims* that it will.

    Say that all doctors told us that eating six pieces of chocolate cake every day is the path to a long and healthy life. And say that the doctoring industry had millions of dollars to invest in marketing campaigns telling people of the critical importance of eating six pieces of chocolate cake each day. How far do you think you would get telling people the realities of nutrition?

    Humans are weak. We all like to eat too much chocolate cake and we all like to believe that Get Rich Quick schemes can pay off in the long run. To believe that there is no need to adjust your stock allocation when prices get insanely high is to believe in a Get Rich Quick scheme. There is zero evidence that this can work either in common sense or in the historical record.

    Your question presumes that people are driven by rationality in choosing funds , that they are looking for the best possible returns. Nothing could be further from the truth. People are driven by emotion. All effective marketing pitches are rooted in emotion. This is why you hear so often that “timing doesn’t work” and that “you can’t beat the market” and so on. All of this is another way of saying — You don’t need to change your stock allocation when stock prices go to insanely dangerous levels.

    It’s another way of saying that eating six pieces of chocolate cake every day is a good idea. It sells. But it doesn’t work. The vast majority of funds (including all Passive Investing funds) are built to sell, not to work.

    Funds will be built to work when we demand that they be built to work. Change happens when the middle-class investors being sold to insist that changes be made.

    Rob

  5. So make an “emotional” marketing campaign for your allegedly superior fund. Then when it beats all the others, you can drop the pitch. Simple.

    Where’s the beef????

  6. “Bankers or some such thing”. Love it. I guess if you don’t what’s actually going on, it’s easier to just try to ignore it.

    “To make an emotional marketing pitch, you would have to make the fund a passive fund.”

    Riiiiiiiight. And you can only make an emotional pitch for a car if it’s blue. Sure…. OK… whatever. So don’t make your pitch “emotional”. Do whatever you like.

    You’re just making excuses for not having a track record. I’d have to be very emotional to fall for that pitch. As an investor, I want actual data, not excuses. Get your fund up and running, make whatever pitch or non-pitch you like, but get some actual returns minus expenses and I’ll take a look at the real data.

  7. So make an “emotional” marketing campaign for your allegedly superior fund.

    To make an emotional marketing pitch, you would have to make the fund a passive fund. If you make it a passive fund, it no longer gets good long-term returns. You can’t have it both ways, Greg. The choice is to go Passive/Emotional/Marketing or to go Long-Term Timing/Rational/Good Long-Term Returns.

    Then when it beats all the others, you can drop the pitch.

    Again, I think that the suggestion here is that “beating all the others” would persuade emotional investors. It doesn’t work like that. Now that Passive has failed, many of those who have advocated Passive for years are saying that the stock crash was caused by the bankers or some such thing. Passive has always failed, every single time it has been tried. But it always comes back. Emotional investing claims have tremendous marketing appeal.

    What I propose is that we educate investors as to what the historical data says about the effect of valuations on long-term returns. Rational Investing can have emotional appeal too — getting better returns at less risk lets us all retire many years sooner. The hurdle today is that The Stock-Selling Industry has spent millions promoting Passive. That doesn’t mean that Rational has no chance. I have spoken with thousands of middle-class investors who have expressed a desire to learn more about the investing realities as revealed in the historical stock-return data.

    Rob

  8. You might be interested in taking a look at my blog entry for today, Greg. It reports on Bogle’s recent comments saying that Valuation-Informed Indexing (the alternative to Passive Indexing) can work:

    http://arichlife.passionsaving.com/

    Bogle did not go so far as to endorse Valuation-Informed Indexing. But I think it is fair to say that we are seeing a big change in the views being put forward by the “experts” since the crash.

    Rob

  9. Carlyle says:

    Passive has failed? What evidence do you have to support that statement? The long-term performance of Vanguard’s Wellington and Wellesly Income fund as well as the Coffeehouse Portfolio seem to contradict your beliefs. But one can easily see from a perusal of your activities online over the past several years, any attempt at carrying on a rational conversation with Rob Bennett is a fool’s errand.

  10. Interesting thread. Just stumbled upon it. Indexing probably comes close to the only “sure thing” there is in the financial world, but lets not be too harsh on Rob. To me it looks like he is basically saying : “Be greedy when others are fearful and fearful when others are greedy”. Didnt Ben Graham also advise something similar ? ie increase your stock allocation during pessimistic times and decrease stock allocation when everything seems rosy. My question tho’ would be : How to tell when valuations are “extremely high” or “extremely low”. Isnt that something you can say only in hindsight ?

  11. Hi Bill.

    Thanks for participating in the conversation.

    I try not to give Rob a hard time. :) (For reference, he’s not the commenter I mention in the introduction to the post.)

    Yes, I believe Graham did suggest adjusting one’s allocation based upon market levels.

    As to what constitutes a high or low valuation, I know that Rob’s method uses P/E-10 (an explanation of which can be found here. Though I don’t know precisely what allocations he’d suggest at given P/E-10 values.

  12. I try not to give Rob a hard time.

    Thanks for that, Mike.

    Yes, I believe Graham did suggest adjusting one’s allocation based upon market levels.

    Graham is also the one who came up with the idea of using P/E10 rather than P/E1 (the more common valuation metric). Much of the confusion about how valuations should be used to adjust one’s stock allocation stems from the fact that P/E1 is an unreliable metric. P/E1 changes too much because of economic good and bad times and thus gives too many false reads. P/E10 is a far more effective valuation metric (by including 10 years of earnings, the effect of economic good and bad times is smoothed out).

    Though I don’t know precisely what allocations he’d suggest at given P/E-10 values.

    A P/E10 of 14 is fair value. Up to 20 is fine. Above 20 puts you in the danger zone. When the P/E10 value goes above 25 stocks are insanely overvalued and extremely unlikely to provide a decent long-term return. We were above 25 for virtually the entire time-period from 1996 through 2008 (we dropped t0 23 for just a few months). The average price drop following the four times in history when we went above 25 is 68 percent real.

    Rob

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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