Sunday, 11 November, 2012

The Individual Investor's Edge

The Individual Investor's Edge

Just came across excerpts from a nice book "Money Makers" by Jonathan Davis. In this book, he comes up with an interesting point: The individual investor has an edge over a professional fund manager. And elaborates with a few reasons.

The more I think about it, the more it sounds appealing. I thought further about the subject. The greatest advantage is simply that the ordinary investor has no need to abide by the rules of the professional game.
Here are a few very valid reasons (some provided by the aforementioned Jonathan Davis, and some based on my own understanding of how the market works):

  • For a start, no private investor has to try and outperform the market: your livelihood does not depend on relative success. Your main concern is the absolute level of return you make on your money, and the risk you have to take to achieve it.

  • As a corollary to the above, it is possible for an individual investor to put all his equity allocation to an index fund and forget it for a long while. A fund manager often can't do so.

  • Private investors are one of the few classes of investors who can often afford to take a genuinely long-term view of their investments. While many professional investors say publicly that they adopt a long perspective, in practice most are still bound by to do if they are genuinely investing for the longer term. Fund managers often have quarterly targets. They need to get their increments, they have their bonus worries, they want their promotions. Individual investors have no such worries. As an example, when Ranbaxy witnessed a change in management, the share prices tumbled to sub-200 levels. A fund manager would have easily found it difficult to buy at 200-250 levels and hold on to those shares. An individual investor could easily have done so, if he had the risk appetite to see even lower sub-200 levels for a short span of time. Today, you all know the prices of Ranbaxy. A similar situation could possibly hold water for stocks like Tata Steel and BHEL which are wildly out of favour. When the tide turns, however, the returns could be great.

  • Individual investors are not burdened with the sheer size of portfolios with which most professional fund managers have to grapple. The bigger the fund, the harder it becomes to sustain an edge in performance. An individual, on the other hand, can easily achieve adequate diversification with a portfolio of anywhere between 7 to 20 companies.

  • A professional investor is constrained by the "nature of fund", "fund house guidelines", etc. For instance, for an equity fund, as per present rules, a fund manager is forced to hold at least 65% in equity shares. An individual investor has no such worries. If he was prepared to do so, nothing prevented him from holding 10% equity and 90% cash when the index hit 21000 in 2008. After all, he knew (as well as the fund managers did) that a whole lot of shares had gone up to crazy heights. Even if a fund manager knew that he was personally uncomfortable holding on to those shares at such high levels, the fund manager could not have "sold out". The individual investor has no such restrictions.

  • When a fund manager buys a share (or sells a share), he has the obligation to "justify" the decision to his internal bosses. On the one hand, this delays the process. On the other, it results in "Group Think", where all members of a team try to be agreeable, rather than to express what's right. The individual investor does not face such restrictions. He can jolly well go by his own analysis.

In terms of inputs (whether data or knowledge), with the explosion of the internet and the plethora of disclosure norms, the individual investor does not face any significant disadvantage vis-a-vis the fund manager.

Still, many individual investors, including the "theoretically knowledgeable" investors do not make enough money in the equity markets.

Besides the problems that are associated with stock-selection, I feel that there are a few key behavioural finance issues that prevents the individual investor from becoming truly wealthy:

  • Information overload - The individual investor tends to believe that "the other guy" knows more - Just because someone writes in a magazine or publishes a blog post or appears on TV, one need not presume that such an individual knows "more than" oneself. After all, NOBODY knows exactly what's going to happen in the market in the near future.

  • Bias for action - This one is linked to the information overload. The individual investor, hearing all the "noise" from various sources, ends up with a strong bias for action. In the markets, "being still", being patient, waiting with your stocks - these are the traits that make you solid money. I distinctly recall buying Titan industries several years ago at a pre-bonus, pre-split price of sub-50. In hindsight, I also know that I had bought it at around the same time as Rakesh Jhunjhunwala made his initial investment in Titan. I got tempted by my "ability to make quick money" and sold out when the share prices doubled. Rakesh is still holding on to Titan. I remain a "retail investor", while Rakesh has become "The Big Bull". Obviously.

  • Greed for more - We're keen to get the last penny from our shares. Hence, despite knowing that a share is overvalued and can only go down, we wait till the music stops. All of us will be familiar with the 2008 story of how the indices fell from 21000 to sub 10000 levels in no time. I just happened to listen to a fund manager a few days back mentioning about how he failed to sell Pentafour Products at over 2000 - He was constantly hoping for more, and today he's left with those shares quoting below Rs. 5/=.

  • Fear factor - This is the converse of Greed - When we know that a high quality company is quoting at ridiculous levels due to temporary problems (either in the company or due to market sentiments), we're way too scared to pick up the shares. A good example would be Tata Motors and Tata Steel. After they picked up Jaguar Land Rover and Corus respectively, the share prices tumbled. Went down to levels so crazy as to become meaningless. And we all knew fully well that the house of Tatas are adequately reliable. We knew about their ethical standards, their management bandwidth, their longevity. Still, many of us failed to pick up those shares at such low levels and hold on to them.

If we can manage to overcome these behavioural "problems", any prudent individual investor who bothers to analyse well before investing can surely become truly wealthy over a period of time. So what if he "underperforms" the index or a couple of fund managers for a couple of quarters or even a couple of years? What matters to the individual investor is whether or not his investments yield the desired wealth over a period of several years.

Happy Diwali!



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