Monday, June 16, 2008 3 comments ++[ CLICK TO COMMENT ]++

What Is Our Edge As (Contrarian) Small Investors?

I'm sure some of you have seen the running debate (in the post comments) between Synchro, ContrarianDutch, and I, on investing styles, philosophies, and the future. Synchro raises one of the the most important questions we, as small investors or contrarians, should get a handle on:

Synchro: By the time it is so obvious that the business is "so misvalued" by you, presumbably it would be obvious to all the other investors too, who are excavating the same grounds. I am at a loss to understand what your edge is.

I'm just a newbie, with a poor investing record, and I don't want to speak for others, but let me provide my thoughts. What Synchro asks is something everything should be able to answer for themselves. The question is, 'what makes you think that you can beat the professionals out there?'

Professionals out there have way more resources. William Ackman spent something like $100,000 on photocopying MBIA documents. My net worth isn't even $100,000! Practically all mutual funds and hedge funds have analysts working for them. Individuals in the industry work 9 to 5 (or more) solely on investing. They can spend their day reading books, articles, or research reports. They can spend their time listening to conference calls. And so on. So what edge do small investors have?

Advantage #1: No Limitations

One of the big advantages that small investors have is that we can investing in anything! You think Japanese stocks are attractive? You can go and buy them. You think large caps are overvalued? Sure, go ahead and avoid them. You feel like doing some risk arbitrage on some announced mergers & acquisition? No problem, nothing is stopping you from taking a position. Your circle of competence will limit you but that's about it.

In contrast, the investing landscape for most professionals is severly limited. Most successful mutual funds or pension funds are too big and can only invest in large-cap stocks. Many funds are also limited to certain industries, sectors, or countries. Pension funds and various institutional funds have strict limitations on what they can invest in (for example, it's hard for them to buy junk bonds whereas if you think GM bonds are worth it, you can go and buy them easily).

Hedge funds have more leeway but even they are quite limited. If size isn't a limitation then liquidity can be a limitation.

I think small investors can capitalize on the limitations of the professionals and go where returns seem highest while risk is lowest.

Advantage #2: Own Money vs Other People's Money

This isn't a huge advantage for small investors (in fact, some might say it is a disadvantage) but it is quite important in my eyes. Small investors are investing their own, treasured, money. Hedge funds/mutual funds/pension funds/etc are investing other people's money. I believe this forces small investors to think things more carefully. There is a big psychological pressure on small investors to be careful. This doesn't mean that everyone is cautious and one can't lose money, but it does give an additional push. Since professionals generally don't invest their money (some do but most don't), their effort may not be quite the same.

I view this scenario as being similar to private property versus public property. If you owned your own car, you would take care of it, try to prolong its life, and so on. But if you ride a rental car or public transportation, you don't care if you wear out the tires, or if you leave it messy, and so forth. Investing your own money is like having your own car; the money most professionals invest is like renting a car. There is a big psychological difference between the two.

Advantage #3: The Instituational Imperative Limitation

As Warren Buffett has elaborated in the past, there is a strong institutional imperative in the business world: the need for managers to act and behave like their peers regardless of how irrational that may be. Warren Buffett was referring to business in general (in particular management behaviour) but I like to apply it to investing professionals. Martin Whitman and Jean-Marie Eveillard have also alluded to similar thoughts.

The reality is that most professional money managers are benchmarked against some index. Their goal is not to maximize returns; instead, it is to avoid deviating from what is perceived as the norm. This is why Jim Cramer was saying that anyone who did not invest in technology stocks in 1999 was literally an idiot. I'm sure he knew that half the stocks in the market were wildly overvalued. But it doesn't matter. The point is to keep up with the market. If the S&P 500 is posting record gains on the back of technology and growth stocks, you need to keep up even if it is the dumbest thing ever. If a professional did not stay close to the benchmark, they, unfortunately, get fired. If an analyst recommends some asset and it drops 50%, that person will be quickly out of a job.

The majority of the investing public keeps the institutional imperative going by mainly rewarding those that stay close to some benchmark and follow the trends. This is why you can have situations like the late 90's where a lot of value funds went bankrupt (due to customer withdrawls) even though they were the last funds that were overvalued (I'm not speaking in hindsight either).

The tendency to keep up with indexes or peers also forces many funds to sell if they take paper losses that are larger than some tolerance limit, rather than holding onto larger paper losses (assuming fundamentals did not change.) In addition, many professional investors are forced to be short-term oriented since their career evaluation is based on their performance in the next year or two.

Even hedge funds, which have lock-up periods, and have clueless wealthy individuals or sophisticated institutional funds as clients are under threat if they don't follow peers.

I personally think that the institutional imperative provides the greatest advantage to small investors, especially if they are contrarian and go against the crowd (although this can be dangerous.) The fact of the matter is that we don't have to do anything! We don't have to keep up with anyone! We don't have to benchmark against some index! We are not going to lose our jobs if we take paper losses!

I know I can't compete against the professional investors so my goal is to try to captitalize on this professional investor flaw.

Last Word...

To sum up, I think there are three key advantages that provide an edge to small investors. Firstly, we can invest in any asset class, anywhere in the world, in any industry. We are somewhat limited by transaction cost and knowledge (circle of competence) but that is just one aspect of it. Secondly, we invest our own money so we have greater psychological pressure to be more careful and think things through. This may be a disadvantage in some investors' eyes but I personally consider it a positive. Finally, and most importantly, we are not victims to the institutional imperative--unless we choose to be.

Good luck to all the small investors out there! :)


3 Response to What Is Our Edge As (Contrarian) Small Investors?

June 16, 2008 at 11:20 PM

Thank goodness you provided a short summary of your post....I'll only say a couple things:

- Precisely because you can do anything and everything in investing, you have ample opportunity to hurt yourself if you don't recognize your own limitation

- I may or may not be managing other people's money, but assuming i do, professionally and ethically I would treat ohter people's money the same way I treat my own money in how I invest it. My first principle is: first, do no harm. Corollary: don't lose it.

June 17, 2008 at 5:43 AM

It has been asked "what makes you think that you can beat the professionals out there". No doubt this question will solicit a different response from everyone who would even dare to answer it.

My response is simply this; my goal is not to "...beat the professionals out there" but to beat myself. To overcome the internal opponents I'll call greed, inpatience, irrational, unpredictable, and uninformed. And as one can imagine, these opponents put up such a fight that there is no time, no strength, and no need to "...beat the professionals out there."

Besides, once these internal foes are "conquered" then an investor is ready to invest more wisely than the many "professionals" who either don't know these opponents even exist within themselves or don't care because it is your money that they are handling and not their own.

Can these opponents be conquered so that the small investor can make profitable investments?


And, the edge is rewarded to the investor, small or large, who accomplishes this.

Be well.

June 17, 2008 at 4:35 PM

Individuals generally do not the the burden of size compared to professionals which opens up market timing.

There is a ton of good info out there, but organizing it into a cohesive framework for investing over 20-50 years is much tougher than anyone would think.

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