Amateurism is bad and professionalism is good. Amateurs are careless and inept whereas professionals are skilful, expert and businesslike. It’s obvious, therefore, that retail investors should behave like professionals and not amateurs.
It might be obvious. But it’s wrong. If retail investors are to beat the market, we should behave like amateurs.
There’s a simple reason for this. Relative performance is a zero-sum game. If someone is to beat the market, someone else must under-perform it. In this sense, the hunt for out-performance is a war, of each investor against the others. If there is to be a winner, there must also be a loser. And one key to success in battle is to fight on terms where we are strong and the enemy is not. As Sun Tzu said over 2000 years ago, “In war, the way is to avoid what is strong and to strike at what is weak.”
If we are to go into battle against professional fund managers, therefore, there’s no point trying to behave “professionally”, as this means fighting against fund managers at their strongest points. By contrast, if we behave “amateurishly”, we have a chance of exploiting fund managers’ weaknesses.
To do this, of course, we must observe another of Sun Tzu’s maxims: “if you know your enemies and know yourself, you can win a hundred battles without a single loss.” (I fear he was exaggerating the pay-offs, but the point holds.)
Where, then, are our enemies’ strong points, the professionals’ advantages?
First, they can usually trade at much lower costs. This enables them to profit from small, short-run mispricings – hoovering up pennies – in a way we cannot.
A further advantage is their access to information. Fund managers have a team of analysts, easy access to companies and – let’s be honest - social contacts which give them an informational advantage over retail investors, at least for bigger companies. We are not going to beat the market if we try to know more than the professionals about Glaxo or Rio Tinto.
Studies show that many retail investors fail to appreciate fund managers’ advantages in these regards. Some, notoriously, erode their wealth by trading too much. And a survey of investors around the world by Brad Barber and Terrance Odean at the University of California concluded that “the evidence indicates that the average individual investor underperforms the market both before and after costs.” This has been corroborated by a recent study of German investors by economists at Goethe University. They’ve found that, on average, stocks bought by retail investors under-perform the market in the subsequent month, suggesting investors are incompetent at spotting shortish-term under-pricings.
However, this doesn’t mean retail investors should give up the battle. Fund managers aren’t so brilliant either. A study by Vanguard Asset Management concluded that “Active fund managers as a group have under-performed their benchmarks”. For example, in the last 15 years 52 per cent of UK actively managed funds have under-performed their relevant index. This figure is flattered by the fact that poorly-performing funds tend to shut down. Including these, 67 per cent of funds under-performed. This isn’t because UK fund managers are unusually bad. Quite the opposite. Vanguard’s researchers found that active managers did even worse in the US and euro zone. There’s also evidence that actively managed exchange traded funds do worse than passive ones.
This fact hints at a hope for retail investors – that professionals have weaknesses. By exploiting these – doing the opposite of what the professionals do – we might win the battle against them. As Sun Tzu said, “If the enemy leaves a door open, you must rush in.”
So, what doors have our enemies left open? Here are a few of their weaknesses, with battle plans to exploit them...
The situation room
Weakness one: liquidity risk. A study of US fund managers by the LSE’s Christopher Polk and colleagues found that even the typical fund manager - let alone the star performer - has a handful of stock picks that beat the market. But the typical fund doesn’t beat the market. This sounds paradoxical, but it’s not. Funds cannot invest in just a few shares because doing so would mean taking massive positions which expose them to liquidity risk – the danger of being unable to sell without moving prices against themselves. To mitigate this risk, funds have to hold other shares. But doing so dilutes returns – often to below average.
However, retail investors, who have much less money to invest, don’t face liquidity risk – unless we buy some very obscure Aim stocks. So we don’t need to spread our investments and so dilute returns.
Battle plan: Concentrate your holdings, by focusing on a few good ideas. To spread equity risk beyond these, hold a tracker fund. Also, if you are a genuine long-term investor, consider buying illiquid investments, such as some private equity funds, as these should pay a premium for their lack of liquidity.
Monthly All-Share returns since 1966
Weakness two: Immobility. Big things can’t move quickly. Funds cannot make large, quick changes to their holdings. This means they cannot exploit one of the biggest and best-attested anomalies – the tendency for shares to do better in the winter than in the summer.
Battle plan: Be a seasonal investor, to some degree. You can switch between equity funds and cash at no cost within a unit-linked pension. Try – without incurring high costs – to hold more cyclical and high-beta stocks in the winter, and more defensive ones in summer.
Weakness three: benchmark risk. What matters to us retail investors is simply whether we make money or lose it. What matters to fund managers, however, is relative performance; the manager who makes 20 per cent when others are making 40 risks losing his job. This gives the fund manager three bad incentives.
One is that he avoids defensive stocks; if he holds stocks that under-perform a rising market, he could lose his job. This means such stocks are under-priced because they carry benchmark risk, and so offer high returns for the investor who is capable of taking on benchmark risk. .
Secondly, he cannot invest in momentum stocks. Victoria Dobrynskaya at the LSE shows that portfolios of recent good performing stocks carry the wrong sort of beta. They have low upside beta, which means they risk under-performing a rising market, but high downside beta which means they risk also under-performing a falling market. This means they carry lots of benchmark risk, which makes them unattractive to professional fund managers. This benchmark risk, however, has a counterpart - high returns. in normal times.
IC Momentum portfolio versus the market
Thirdly, the professional cannot stick to strategies that are profitable in the long-run on average if they suffer short-term losses. Compare the fates of Warren Buffett and the late Tony Dye during the tech bubble. Both avoided tech stocks in the belief they were overpriced. Mr Dye, being an employee, was sacked in 1999 for under-performing – shortly before his scepticism was vindicated by a slump in tech stocks. Mr Buffett, however, was his own boss and so was able to stick to the policy of holding quality stocks. He made a fortune as these came back into fashion.
Retail investors, however, aren’t exposed to benchmark risk or the risk of being sacked for temporary poor performance. So we shouldn’t behave as if we are.
Battle plan: Hold defensive and momentum stocks, to reap the (long-term, average) risk premium they carry as the counterpart to their benchmark risk. Stick to tried and trusted strategies – defensives and quality stocks – even though they suffer bad times occasionally.
Weakness four: herding. The fact that fund managers risk the sack if they under-perform gives them an incentive not to deviate from average behaviour. This incentive is exacerbated by a cognitive bias – deformation professionelle, the tendency that all professionals have to think alike by virtue of their training.
These pressures can give rise to herding behaviour, in two ways. One is that fund managers want to get onto band wagons – such as tech stocks in the late 90s or commodity stocks in the 00s. This can generate momentum effects, of which post-earnings announcement drift (the tendency for shares to rise even days after good earnings news) is a particular case.
The other is that fund managers share a general outlook towards stock-picking. This can cause them to over-emphasise “fundamentals” - data about company and economic performance – because these are what they have been trained to analyse, to the detriment of other influences upon returns such as cognitive biases.
Battle plan: Exploit momentum effects intelligently. This means cutting losers and running winners. And although it doesn’t mean chasing every winner – that risks buying at the top of a bubble – it does mean factoring in momentum to your stock-picking; a good stock with momentum is better than one without it. Also, look out for stocks which might be mispriced because of cognitive biases; small speculative growth stocks might be overpriced because of the wishful thinking bias, but some stocks enjoying recent good news can be under-priced because of investors’ under-reaction. Fund managers are strong at analysing company fundamentals, but perhaps weaker at analysing cognitive biases.
Weakness five: ego involvement. Fund managers have to justify their salaries. One way they do so is by trying to use skill and judgment. This is dangerous. We know from cognitive biases research that judgement can go wrong in countless ways. And even when it goes right, it can have nasty consequences, as successful stock-picking can breed an overconfidence which emboldens us to take bigger risks.
But perhaps investors don’t need judgement. Economists at AQR Capital Management have shown that Warren Buffett’s success is due not to especial individual stock-picking skill, but to the strategy of buying “quality” stocks – those with good and rising profits with a decent payout ratio. These are things that can be identified by no-thought stock screens. You don’t need ability.
Battle plan: Don’t fall into the trap of thinking that investment is about you. Take the ego out of investing. One way to do this is to use stock screens to select quality, defensive or momentum stocks. Also – though this is difficult to do - never get carried away with success. There are sometimes good reasons why we might want to take more risk. But the fact we’ve done well recently is not one of them.
Weakness six: the action bias. One drawback with working for a living is that we feel the need to justify our salaries by doing things. But action is sometimes useless or worse. For example, researchers have shown that goalkeepers would (for a while at least) save more penalties by standing still than by diving. Sometimes, doing stuff is positively disastrous: RBS shareholders would be much better off if Fred Goodwin had played golf rather than gone to the effort of buying ABN Amro.
The same is true for fund managers. As we’ve seen, beyond a handful of stock buys, their work actually subtracts value. This shouldn’t be surprising. It’s just the old law of diminishing returns.
But the costs of doing things and presenteeism might be wider than that. It might slow down the process whereby fund managers get good ideas. Steven Johnson, author of Where Good Ideas Come From, points out that ideas come from making connections – either by meeting other people or from making connections between pre-existing ideas. But this often happens in downtime or – in John Kay’s beautiful word - obliquity. For example, Charles Darwin had the elements of the theory of natural selection for a long time but it was only when he read Thomas Malthus’s Essay on Population that he connected these elements into a full theory. But he was only reading that Essay “for amusement.” Great innovators have something in common, says Johnson: they have lots of hobbies. Being stuck at a desk surrounded by the same old faces isn’t the best way to generate ideas. “Professionalism” can be the enemy of creativity.
Retail investors, however, don’t need to be busy, or even look busy.
Battle plan: Don’t feel the need to do things. Sometimes, the best thing an investor can do is go for a walk or to the pub. This can save us from trading too much, or investing at times when the balance of mind is clouded by emotion. And it might even have the positive benefit of giving us the good ideas that come from having a clear head.
We have, then, a pretty clear plan for battling against the experts. However, I’m not sure you can pick and choose among the individual elements of this plan. For example, the advice to concentrate your portfolio works only if you are using good stock-picking principles of favouring quality, momentum and defensives; if your concentrated holdings are based on wishful thinking or “judgement”, you might merely concentrate your losses.
Nor am I even sure that these principles guarantee success. Markets are, after all, mostly efficient which means beating them is hard. Father Brown was right to say that “Professionals built the Titanic, but it was an amateur who built the Ark.” But he omitted to add that the Titanic and the Ark were both rarities. If we amateurs are to have a hope of beating the market, it lies in the fact that investing isn’t like shipbuilding, and Titanics are more common.