A lot of individual investors mistakenly believe that it’s impossible to beat the results achieved by professional investors. This could not be further from the truth according to Joel Greenblatt in his great investing book – The Big Secret for the Small Investor. Greenblatt illustrates how small investors can outperform investing professionals saying:
“As individual investors, we have some major advantages over the large institutions. We don’t have to answer to clients. We don’t have to provide daily or monthly returns. We don’t have to worry about staying in business. We just have to set up rules ahead of time that help us stay with our plan over the long-term. We have to choose an allocation to stocks that is appropriate for our individual circumstances and then stick with it.”
Here’s an excerpt from the book:
The truth is that it’s really hard to be a professional stock market investor today. The march of technology has made it easy for clients to monitor returns, and in many cases to scrutinize investment positions on a daily basis. The lucky managers, the ones who have clients with a “long term” perspective, get to report results on a monthly basis. Since most clients can only evaluate performance results (rather than the quality of the work that went into each investment decision), there have been a million ways developed over the last few decades to slice and dice these performance data into all kinds of ratios and statistics.
The only thing is that evaluating past performance data for even a several-year period may be unhelpful when it comes to predicting future success. Yet almost all hire-and-fire decisions made by clients (both individual and professional) are based on a manager’s performance during the last couple of years. While this is perhaps understandable, it forces most managers to concentrate on short-term performance. As we’ve already discussed, even if a manager has a healthy longterm perspective and is willing to wait out short-term underperformance, most clients are not! After two years of underperformance, or three years at the most, most clients leave. Just as important, after two or three years of underperformance, there is almost zero chance of getting new clients. Under those circumstances, what’s a manager to do?
In the late 1980s, I had just signed up a new client for our investment partnership. This client was one of the first investment firms known as a fund-of-funds. These are professional investors who collect money from clients but do not manage the money themselves. Instead, the managers of the fund-of-funds use their expertise to select a group of “good” managers and invest the money with them. At the time, I was providing performance information to my clients on a quarterly basis. At the request of my new client, I agreed to provide the fund-of-funds with performance returns each month.
Sure enough, after one month our partnership was up 1.1 percent. Not bad, except that our new fund-of-funds client called and informed us that other similar partnerships in which they had invested had been up an average of 1.2 percent during the same period. To what did I attribute our “underperformance”? (No, I’m not kidding.) As politely as I could, I suggested that perhaps they should call me back in a year. Of course, if I had responded that a more meaningful period over which to evaluate our performance would probably be four or five years, that would have been closer to the truth. Then again, I’m pretty sure that bit of investment wisdom would have been met with a suggestion to “be fruitful and multiply” (but, as Woody Allen would say, not exactly in those words).
Well, institutional investors dominate the stock market even more today than they did twenty years ago. The practice of providing daily or monthly information and analysis on investment performance is standard operating procedure. Everyone does it. It’s expected, and in most cases it’s required.
Today there’s absolutely no chance that any fund-of-funds would graciously agree to call back in a year. In fact, investment fiduciaries, such as the managers of pension funds, endowments, insurance companies, and fund-of-funds, would be considered negligent if they didn’t continually monitor and actively analyze the activities and performance of the fund managers to whom they allocated client assets. This is completely understandable. As a fiduciary myself in several situations, I need to do it, too.
It’s just that it’s really hard to look at returns every day and every month, to receive analysis every month or every quarter, and still keep a long-term perspective. Most individual and institutional investors can’t do it. They can’t help analyzing the short-term information they do have, even if it’s relatively meaningless over the long term. On the bright side, as the market has become more institutionalized and performance information and statistics have become more ubiquitous, the advantages for those who can maintain a long-term perspective have only grown.
For those investing in individual stocks, the benefits to looking past the next quarter or the next year, to investing in companies that may take several years before they can show good results, to truly taking a long-term perspective when evaluating a stock investment remain as large, if not larger, than they have ever been. Remember from early in our journey, the value of a business comes from all the cash earnings we expect to collect from that business over its lifetime.
Earnings from the next few years are usually only a very small portion of this value. Yet most investment professionals, stuck in an environment where short-term performance is a real concern, often feel forced to focus on short-term business and economic issues rather than on long-term value. This is great news and a growing advantage for individual and professional investors who can truly maintain a long-term investment perspective.
Luckily, since it’s particularly hard for most non-professionals to calculate values for individual stocks, this focus on the short term by professionals is also a huge advantage for individual investors who follow an intelligently and logically designed strategy like our value-weighted index. Because value strategies often don’t work over shorter time frames, institutional pressures and individual instincts will continue to make it difficult for most investors to stick with them over the long term. For these investors, several years is simply too long to wait.
That’s why “Part B” [see below for Part B] of our plan is so important. Hanging in there will be tough for us, too. But as individual investors, we have some major advantages over the large institutions. We don’t have to answer to clients. We don’t have to provide daily or monthly returns. We don’t have to worry about staying in business. We just have to set up rules ahead of time that help us stay with our plan over the long term. We have to choose an allocation to stocks that is appropriate for our individual circumstances and then stick with it. When we feel like panicking after a large market drop or ditching our value-weighted strategy after a period of underperformance, we can—but only within our preset limits. When things are going great and we want to buy more, no problem, we can—we just can’t buy too much. “Part B” of our plan won’t let us!
So there it is. We have a strategy that beats the market. We have a plan that will help us hang in there. And, as individual investors, we have some major advantages over the investment professionals. All we need now is a little more encouragement. Perhaps a final visit with Benjamin Graham will help push us on our way.
In an interview shortly before he passed away, Graham provided us with these words of wisdom:
“The main point is to have the right general principles and the character to stick to them.… The thing that I have been emphasizing in my own work for the last few years has been the group approach. To try to buy groups of stocks that meet some simple criterion for being undervalued—regardless of the industry and with very little attention to the individual company.… Imagine—there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up.”
That interview took place thirty-five years ago. Yet we still have an opportunity to benefit from Graham’s sage advice today. I wish you all—the patience to succeed and the time to enjoy it. Good luck.
PART B
Pick a number. What percentage of your assets do you feel comfortable investing in stocks? The important thing is to choose a portion of your assets to invest in the stock market—and stick with it! For most people, this number could be between 40 percent and 80 percent of investable assets, but each case is too individual to give a range that works for everyone. Whatever number you do choose, though, I can guarantee one thing: at some point you will regret your decision.
Being only human, when the market goes down you will regret putting so much into stocks. And if the value-weighted index goes down more than the market, you’ll regret it even more! If the market goes up, the opposite will happen—you’ll wonder why you were such a chicken in the first place. And at some point, if the popular market indexes outperform the value-weighted strategy for long enough, you’ll wonder why you listened to me at all! That’s just the way it is. (Actually, according to behavioral finance theory, that’s just the way you is!)
So here’s what we’re going to do. Against my better judgment, we’re going to give you some rope to play with. Once you pick your number, let’s say 60 percent in stocks, you can adjust your exposure up or down by 10 percent whenever you want. So you can go down to 50 percent invested in stocks and up to 70 percent, but that’s it. You can’t sell everything when things go against you, and you can’t jump in with both feet and invest 100 percent when everything is rocking and rolling your way. It’s not allowed! (In any event, doing this would put you in serious violation of Part B of our plan!)
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