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Beating the professionals

Some professional investors think retail investors are mugs. This doesn't have to be the case
August 15, 2018

Professional investors think you’re a mug. In his superb history of fraud, Lying For Money, Dan Davies says retail investors are “dumb money”. Not only are they unlikely to have inside knowledge, he says, they often haven’t fully digested all public information. This means that although they account for only a small fraction of the market – only one eighth of shares are owned directly by individuals – they are very useful, he says, because professional investors can trade against them confident that they know better.

Which raises a question. If fund managers have this advantage, why don’t they perform better? We know that active funds don’t on average beat the market. This suggests that they have some offsetting disadvantages. To put this another way, we retail investors might have some advantages over them which we can exploit.

One is that we don’t need to worry about liquidity risk in quoted shares.

In a classic paper the LSE’s Christopher Polk and colleagues showed that even average fund managers have a handful of stocks that go on to beat the market. This is consistent with them having an information advantage over retail investors. But the average fund does not beat the market. This is because it owns more than a handful of shares, and these others dilute its performance. It does so to reduce liquidity risk. If a £200m fund had only 10 holdings, it would hold over 2 per cent of some FTSE 250 companies. Such big positions would be difficult to acquire without raising prices against oneself, and would be impossible to sell quickly at good prices. To avoid such problems, most funds have more but smaller holdings.

Retail investors, however, don’t have this problem. We can limit our shareholdings to a few thoroughly researched companies and can spread risk beyond them with a tracker fund. We don’t need to hold shares we haven’t researched properly or have little confidence in merely to top up the numbers.

A second advantage we have is that we don’t need to be busy.

Even if stock markets are inefficient they are not so much so that they throw up big and obvious mispricings very often. This means that hard work doesn’t necessarily pay: if there are no mispricings, no amount of hard work will uncover them any more than hard work digging on Skegness beach will strike oil. Investors should therefore spend most of their time doing nothing but research, thinking and waiting. People who are stuck in offices are less able to do this; they feel obliged to look busy. Retail investors, however, are better able to do nothing.

Thirdly, retail investors can take a risk that many professionals cannot – benchmark risk. Fund managers are judged against their peers: they lose their bonus or job if they underperform. This means that defensive stocks are dangerous for them, because they would underperform a strongly rising market. Because they avoid such shares, these tend to be underpriced and so outperform the market in other times; we have evidence from around the world and for long periods that defensives do better than they should in theory. They offer a risk premium. Retail investors can pick this up by buying defensives and taking a risk they need not worry about.

We have a fourth advantage. Many fund managers need to appear moderately conventional. They earn trust by looking like what Paul Krugman called “very serious people” (he didn’t intend this as a compliment) – those who seem clever by conventional standards. They do this by behaving in a conventional way – analysing stocks in standard ways and making judgments about macroeconomic and market conditions.

Everybody’s professional training, however, runs the risk of distorting their perspective: the French call this deformation professionelle. Retail investors can exploit this.

One way we can do so is through buying momentum stocks. 'I’ve bought these because they’ve gone up a lot' is a difficult message for a fund manager to tell his clients. But it’s a strategy that works. Retail investors can implement it because we don’t need to appear conventional.

We can also be seasonal investors whereas fund managers cannot. For one thing, to do so requires one to believe that market sentiment is swayed by the time of year – which sober-minded fund managers are loath to admit. And for another, it’s expensive to liquidate a big portfolio in the spring and but it back again in the autumn. Some of us, though, are not so constrained; we can switch our pension funds between equities and cash at no cost.

So yes, it is the case that fund managers have an informational advantage over us. They have time (and big staffs) to research stocks thoroughly, and have better access to companies. But they also have disadvantages arising from their size, the risks they face, and from their need to appear conventional. If retail investors are to stand a chance of beating the market, they should do so by exploiting these weaknesses.

In fact, some do just this. Joshua Coval, David Hirshleifer and Tyler Shumway, three US economists, have found that the best-performing 10 per cent of retail investors do indeed earn above-average returns – so consistently so that this isn’t mere luck. This, they believe, is because they are not as constrained as professional fund managers by liquidity risk.

Of course, you might think you are not in this 10 per cent. If so, you have a very simple alternative – to buy tracker funds. These won’t beat the market, but they’ll guarantee you something very close to a draw. And with average luck, this will be good enough to grow our wealth over time.