Why a Small Investor Can Beat the Market But the Mutual Fund Manager Cannot
May 31st, 2010 Filed under: online wealth,Wealth Advisory,wealth builders,wealth strategies — Wealth Building Author
Pick up a copy of Money magazine or other similar publications and read a few articles and you’ll find the conventional wisdom — the retail investor will not beat the return of the indexes over time, so don’t even try. Just stick your money in a cheap mutual fund, such as an index fund, and let it ride. The research will show that the large majority of professionally managed mutual funds trail the performance of their non-managed index brethren, so there is no reason to try to pick stocks.
This advice is absolutely true for managed mutual funds. But there are investors out there — many of them in fact — who have been able to beat the markets through managing their own accounts. This was discussed in a 2005 article in Canadian Business magazine.
So, why is it that actively traded mutual funds, where a management team will scan through the thousands of stocks and direct investor’s money in to their top picks, will trail a mindless index fund that just buys whatever is in the index? And why is it that individual investors can beat the index funds and the actively managed funds over the long-haul? Ironically, small investors can be the mutual fund behemoths because they are small.
A mutual fund manager needs to stay fully invested most of the time, with little cash sitting on the sidelines. If he doesn’t, his results will lag the market when it advances and investors would pull money out of his fund and go to someone else’s who did at least track the market. Who would stay in a fund that made 10% in a year when the market advanced 30%?
Most mutual funds also have billions of dollars under management. They have so much money to invest that their investments can move the price of a stock one way or the other. If they want to buy into a stock, they will run out of sellers at the lower prices, causing the stock price to move up, forcing them to pay more for the shares. Likewise when they wish to liquidate a position, as they sell traders will see millions of shares entering the market for sale, causing the price to drop as supply exceeds demand.
For these reasons, a mutual fund manager is at a disadvantage to the small investor. Even if a mutual fund manager is a great stock picker and has an expansive research staff. Even if she travels to all of the companies in which she considers investing to evaluate the business and talk to the management, she will always need to buy more than her top picks in each market segment because there simply isn’t enough stock out there in a few companies to be fully invested. She would end up being the only investor in the company and pay an enormous price to get all of the share she wanted. The mutual fund manager therefore ends up buying her first, second, third, and probably fourth pick, and buying shares in market segments with which she isn’t particularly thrilled.
Because the fund manager needs to buy so many different stocks to become fully invested, the mutual fund ends up buying enough different stocks to basically track the market. The portfolio will therefore just track the return of the market because it is the market. If Apple does better than Dell and gains market share it doesn’t matter to the mutual fund because it owns shares of both Apple and Dell. Even great investor Warren Buffett has said that it has become very difficult lately because he has so much money to invest that he can’t be as nimble or as picky as he would like.
The small investor does not have this trouble. With $10,000, $100,000 or even $1,000,000 to invest a small investor can pick just the stocks he really likes and concentrate his holdings. When he buys 1000 shares he does not even cause a hiccup in the price of most stocks. A good stock picker, with the emotional fortitude to stick with a plan through good markets and bad, can therefore outperform both actively managed funds and the indexes. An investor who bought 1000 shares of Microsoft, Apple, IBM, Home Depot, and others would be a multimillionaire today.
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For information on specific strategies by which a small investor can beat the markets, along with information on stock picking and other topics, see the Small Investor blog: http://smallivy.wordpress.com
