Tuesday, December 4, 2012

Private Investors Outperforming Professionals?

At some point in his/her investing life, every private investor is faced with the same question: Does he actually add value by investing himself or not?  I suspect the most common response is to ignore the question safe in the notion that it’s just a bit of fun on the sideline. Another is to avoid the complication of benchmarking performance and just be happy that the account is positive. However, for full time investors, the issue simply cannot be avoided.

Discerning readers will note that I specifically reference private investors here. The reason is that professional investors are not that as exposed in how they earn money (fees, etc.) to the vagaries of performance. Private investors lose money when performance is negative. Do money managers refund fees?

Why Professionals Aren’t Trying to Outperform

It gets worse: The investment industry has learned a fundamental truth of behavioral finance and constantly applies it. I’m talking about the tendency of investors to psychologically weight a loss double that of a gain.

Asset managers understand this because they realize that investors will overweight a losing performance versus a winning one. In other words, if an asset manager underperforms for a client his downside risk (losing assets under management) is far greater than the upside from outperforming. Now you know why the investment industry produces such ‘samey’ benchmark-hugging performance. It’s in their interests to do so.

If there was a difference between what, say, T Rowe Price (NASDAQ: TROW) and Ameriprise Financial (NYSE: AMP) did, surely it would show up in marked differences in share price performance?

AMP data by YCharts

And investors in these companies should understand that they are just making a highly correlated bet on the markets by buying them.

A Waste of Talent

I'm not saying there aren’t a lot of talented people in the investment industry. There are, and in their ‘defense’ I should point out that it is hard to outperform when you are not really trying to do so! While this may be disheartening for the young investment professional anxious to prove himself by generating performance, he is soon overwhelmed by the pressure to conform to the industry game of focusing on getting assets under management (AUM) and not particularly bothering about performance.

Remember folks, given the same performance fee, an asset manager generating 5% with $1 billion AUM earns more than a guy generating 12% with $400 million. Who would you rather be? Also consider that during a down year the whole industry will suffer. As none of the major firms with AUM will deviate from each other’s performance they will all make the same excuses and try and hang onto AUM as best they can.

Some of these clowns even try to sell you their services without a track record. If I want my car window replacement, I go to someone who does it every day and is tried and tested at doing it. Alternatively, if I want my money invested, should I go and give it someone who won’t even tell me how good he is at what I am paying him to do?

Confidence is the Key

Turning back to the challenge for private investors confidence only really resonates with someone if it is accompanied by extensive experience. It is something hard won but easily lost. I’ve outperformed the market for years and across different market conditions. No matter. When I have a couple of months of underperformance, I start to stress. I’m the worst investor ever, this is all a waste of time, I am losing money. My hard earned money.

The usual ‘confidence boosting’ supporting arguments kick in. Historically, you lose money 4/12 months a year so it’s just random that two are next to each other. Look at the long term chart, you had blips before. You outperformed for over 10 years so what is two months in the scheme of things? It’s all good stuff but the truth of it only rings true when you get back to a profitable month. It is a stressful game.

Private Investors Edge

So, when under this stress, why exactly should private investors feel they can outperform? Why should they feel they can add value when all the empirical evidence suggests that fund managers don’t do so?

The answer lies in the fact that private investors are actually trying to outperform rather than mimic a benchmark. They don’t have to diversify away returns by constant adherence to sector weightings in the benchmark indices. In addition they are not obliged to be in the market just because they are trying to generate a buck in management fees. Private investors have far more flexibility.

For example take a stock like General Electric (NYSE: GE), which is going to see its prospects correlated with global GDP growth. Here is how the market priced it in 2000:

GE PE Ratio TTM data by YCharts

The good news is private investors don’t have to pay 50x earnings, while professional investors have to hold it. Another example is Google (NASDAQ: GOOG), of which we can see revenue growth here.

GOOG Revenue Quarterly YoY Growth data by YCharts

It is in a nice uptrend since the recessionary dip, and even with the transition to mobile and tablet Internet usage, Google still has a dominant position in search. However, every fund manager this year was forced to listen to the hoopla and hype surrounding Facebook (NASDAQ: FB) just because one part of the investment industry wanted to sell something to another part of the industry. However, amidst all this, very few people actually pointed out that Facebook had no articulated plan for mobile at the time of the IPO. No matter institutional investors were obliged to pick some up due to benchmark weighting issues. Private investors could avoid it altogether. Meanwhile Google goes on churning out revenue growth.

The Bottom Line

In conclusion, I think there are a whole bunch of reasons why hard working private investors can outperform professionals. It’s a stressful process, but then again it is a whole lot more stressful to look back on 10 years of miserable returns for you and then add up what your investment advisor has made out of this process. Despite the puff that the investment industry churns out, private investors are better placed to generate alpha. The real issue is having the confidence to keep doing it. Hopefully reading and participating in this sort of online forum will help!


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