Individual investors – normal people with some cash in a brokerage account – have a big advantage over “smart money” (or investment professionals, like hedge funds and unit trusts). But it’s an advantage that you might not think of… and you have to know how to use it.
As we wrote recently, professional investors have a lot of resources to study where markets and securities are headed. They have access to oceans of data, and teams of analysts to find the pearls in those waters. In this way, they have a huge advantage over individual investors.
But despite these resources, the “smart money” can rarely beat the market index they’re measured against. Individual investors usually earn better returns by investing in a low-cost market index ETF (like the SPDR Straits Times Index ETF for Singapore’s STI (code: ES3), or the Tracker Fund of Hong Kong (code: 2800) that tracks the Hang Seng index).
That’s partly because the fees charged by money managers hurt performance. A market index ETF charges very low fees by comparison – so performance is better.
But besides expenses, the other big reason that “smart money” usually can’t beat their benchmark is time. Professional investors don’t have the luxury of time to wait to see if their investment idea will work… and they often have to sell and move on to the next idea before it can.
That’s because investment professionals are often paid based on the performance of their portfolio over specific, short time periods. If the fund they’re running does better than the index over (say) the three-month period of a quarter, they’re paid a bonus as a reward for this accomplishment.
But if the fund they’re managing underperforms the index, they might not be paid a bonus. And if they do worse than the index for a few quarters in a row, investors might start to take their money out of the fund. This leads to a lower bonus for the portfolio manager. Or, worse, the portfolio manager might lose her job altogether. (Some money management companies talk about how they’re “long term investors”… very few actually are.)
What that means is that every quarter, the clock is set back to zero. Last quarter’s performance doesn’t matter anymore. So a portfolio holding that hasn’t moved up at least as much as the index is “dead money” and carries enormous opportunity cost. Having too much dead money is like running a 100-metre race – while carrying a brick in each hand.
So a lot of the “smart money” is buying and selling against the clock during the quarter… because if a stock isn’t moving up, it’s like a brick holding it back from winning the race to the quarterly finish line.
Individual investors, though, rarely have a time constraint. There’s no one peering over your shoulder, demanding to know why you haven’t sold a stock that’s been flat… or that’s down a bit. You might be relying on your portfolio for your retirement – but quarter-to-quarter performance doesn’t really matter. If you have an idea that you really believe in (and if your stop-loss isn’t triggered), you can afford to wait.
Of course there is still a very real opportunity cost to everything you own (we’ve written about this before). But you won’t lose your job if you accept the cost of opportunity.
What does that mean in practical terms? It means that – unlike the “smart money” – you can afford to wait. For example, the graph below shows the share price performance of Singapore-listed real estate company CapitaLand (Singapore; code: C31) in the early 2000s.
For a few years, the share price of CapitaLand drifted, from a bit over S$1, to a low of S$0.73, and then slowly drifted back up. But it didn’t move much for years (“not interesting” on the graph).
Most professional investors would have lost patience with CapitaLand. Or some might have taken a position in it… and then sold a quarter later, after the share price barely move.
An individual investor who firmly believed that CapitaLand was worth holding on to, though, would have been rewarded with a 600 percent return over a 4 to 5-year period. Along the way – as the share price started to appreciate – the “smart money” might have joined it… but few of them would have had the patience to wait.
Individual investors are at a big disadvantage… but the power of time is one advantage they have over the “smart money.”