Why Small Investors Don’t Stand a Chance

small-investor-no-chance Investing is hard for professionals, and even harder for amateur investors.  Especially when success is not measured in a cumulative manner – a dozen years of good work can be undone by a bad quarter.

I have written about the many difficulties of achieving consistent good performance: from minding the myriad of intersecting forces in order to stay above the water, the skills needed to balance long-term investment principles with technical knowledge, to blocking out noises that only confuse investors.  On top of all that, it also serves to see the big picture, particularly forces related to social and demographic shifts.  There is a lot to take in – which would explain why so many of us delegate the task to other people.

Yet for all those financial advice we consume from both paid and free sources: advisors, newspaper columns, personal finance and investment magazines, business TV programs and water-cooler conversations, most small investors find themselves unprepared and worse yet, unprotected from the financial storm that swept through much of the world in the past half year.  After coming across Jeffrey Goldberg’s recent article, I am more convinced than ever that it is next to impossible for a small investor to make it in the stock market.

The small fish gets Jiffy Lube advice

Most of us have assets less than, say, $10 million.  And that’s about the threshold that determines whether one gets the attention of a top-flight money manager, or a print-out from a cookie-cutter computer program.

In the article, Goldberg highlights the pressure to provide conventional advice.

Advisers only recommend what’s conventionally palatable. They tend to say 60 percent stocks, 40 percent bonds, and they’re not likely to move away from that, no matter how extreme valuations are. They’re not likely to move away from it when the market is really high, or really low. A big part of the problem is that there isn’t a perfect answer to any of this. No one can tell you how to allocate your assets 100 percent of the time. The average investor is not getting Warren Buffett to look at his portfolio; he’s getting a printout from a computer model.

Knowing the average investors’ aversion to risk, but feeding on their hopes for ever-higher returns, an investment advisor cannot be blamed for holding up the mutual funds and stock market charts that always “trend” up and to the right.  And not wanting to miss out the double digit returns from merely parking one’s money in an investment account, most investors hand over their assets and turn on their “buy and hold” mode.

Timing matters a lot

In fact, much of the personal finance field spews out more or less the same bland and conformist conventions.  Some of the advice has proven to be sound and timeless, but many are much too general.

For example, if one marches into an investment advisor’s office today and ask for advice on dealing with a much lighter portfolio, one is most likely to be told to extend her “investment time horizon”.  This obviously doesn’t work for someone ready to cash out of his 401K after a lifetime of work and savings, or parents counting on the market to pay for their children’s impending education.  And the investment industry is hypocritical for attempting to dispense advice as though we are starting from zero, and not the minus fifty percent that many of us are finding ourselves in.

On that note, I think it’s good to stress that a singular commitment to the traditional buy-and-hold strategy, without taking into account the issue of market entry and exit timings, will get investors into trouble.  The market moves cyclically, and in the long run, it usually moves up.  Unless you’re in Japan, of course, where the market has sunk to 1983 levels.  But in most cases, let’s suppose the rightward and upward trajectory holds.

But if and when someone is caught in the peak and trough of an economic cycle, where their financial surplus and obligations are in fact more fitting for something of the reverse, then a blind faith in the long-term wisdom of the market will either have you enter the market when it’s already overbought, or cash out at a time when the market is oversold.  To mitigate such risks, financial planning needs to incorporate not only market movements, but whether volatility and riskiness of staying in the market is commensurate with one’s changing financial needs.

Customer of many, friend of none

A small investor doesn’t have a lot of friends.  At least not many that actually have their interests at heart.  The wealthy are taken care of by “wealth management” businesses that “gather assets from wealthy people and then place those assets with a whole bunch of managers who will manage different pieces of it in diversified styles so you don’t lose it all at once.”

The everyday investors must sift through the many personal finance columns, magazines and questionable business television programs for some sensible advice.  And those media outlets are only too happy to occupy the vacuum left by institutional and hedge fund managers.

Run-of-the-mill advice are for the uninitiated and get pretty old fairly soon.  But once investors decide to become more actively involved in self-education, he is bound get confused very soon.  Contradictory advice abound: gold or dollar, inflation or deflation, recovery or bear market rally?

The various models and theories used to price assets, measure progress and project the future are just that, models and theories.  There are people behind the scene performing stress tests, incorporating more variables, performing tweaks and adjustments all the time.  The interconnected economies complicate matters, political interests and politically dominant corporations complicate matters, unexpected behavioural shifts complicate matters, and sociological and demographic shifts complicate matters.  The market is influenced by so many unknowns, even economists can best provide outlook and analysis based on what they know.

Curiously enough, economics is also one area of academia that opened up its laboratory to the masses.  Very few of us will ever get to witness a medical procedure, or participate in a chemistry research project.  But almost all of us are involved in an ongoing social and economic experiment that is spearheaded by the stock market.  And through either voluntary or induced participation, we are required to live with a level of uncertainty not commonly known to some parts of the world.

Perhaps some of us will elect to step out and stay out of the market after this wild ride comes to an end.  Because finding someone competent enough to advice you is very hard when you are a small investor.  And finding advice on a piece-meal basis is even more dangerous, because to be selectively informed is worse than being uninformed.  In Bill Gross’ opinion, “The system is rigged.  It’s difficult for the average investor to even conceptualized what we’re talking about.” But if you insist on finding good returns from the market, then you should at least “find someone who isn’t overpromising or overcharging.”

picture source: ~Cypisek666

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  • http://www.ockhamresearch.com Christian Ward

    Great write up.

    It is so hard for small investors to get ahead, and in many ways that tends to have much less to do with the pros only working with the wealthy and much more to do with the fact that individuals are busy working their jobs and raising their families. They don’t have the financial cushion that presents the opportunity to stay informed at all times, or hire the hordes of advisors paid to do that for them.

    But don’t be mistaken about performance or attribution. Many professionals lose money for their clients at an astounding rate. Individuals who stick to low cost (ETFs vs. Funds) options and individual stocks typically can far outperform just handing their money over to an advisor or mutual funds. Much of what is typically lost is not due to bad ideas or investment concepts, but poor timing (as you point out) and emotional, reactionary trading. And the biggest barrier is staying informed at all times. It’s hard to compete, when you don’t know the game has changed or that it is even being played until after you finish your day job at 6:54pm.

    One other thing. You state,

    This I must protest. I have worked with over 450 independent research firms in the last 10 years, documenting their performance. Some are humans, some are computers. The reality is that the computers typically dominate performance wise. It’s the outlier situations that only humans can understand that provide the alpha from the quick-thinking manager. In other words, the computer is more often than not correct in when to buy airline stocks. But the computer cannot react instantaneously to an airline crash, assimilate that news into its investment criteria, and make the appropriate decision the way a human can. So the trick is to use computers (or more accurately mathematics) and overlay an informed approach.

    Honestly, the only thing a “top-flight” manager will definitely get you, is a 1% to 2% loss off the top, which goes in their pocket.

  • http://www.ockhamresearch.com Christian Ward

    Great write up.

    It is so hard for small investors to get ahead, and in many ways that tends to have much less to do with the pros only working with the wealthy and much more to do with the fact that individuals are busy working their jobs and raising their families. They don’t have the financial cushion that presents the opportunity to stay informed at all times, or hire the hordes of advisors paid to do that for them.

    But don’t be mistaken about performance or attribution. Many professionals lose money for their clients at an astounding rate. Individuals who stick to low cost (ETFs vs. Funds) options and individual stocks typically can far outperform just handing their money over to an advisor or mutual funds. Much of what is typically lost is not due to bad ideas or investment concepts, but poor timing (as you point out) and emotional, reactionary trading. And the biggest barrier is staying informed at all times. It’s hard to compete, when you don’t know the game has changed or that it is even being played until after you finish your day job at 6:54pm.

    One other thing. You state,

    This I must protest. I have worked with over 450 independent research firms in the last 10 years, documenting their performance. Some are humans, some are computers. The reality is that the computers typically dominate performance wise. It’s the outlier situations that only humans can understand that provide the alpha from the quick-thinking manager. In other words, the computer is more often than not correct in when to buy airline stocks. But the computer cannot react instantaneously to an airline crash, assimilate that news into its investment criteria, and make the appropriate decision the way a human can. So the trick is to use computers (or more accurately mathematics) and overlay an informed approach.

    Honestly, the only thing a “top-flight” manager will definitely get you, is a 1% to 2% loss off the top, which goes in their pocket.

  • http://onemint.com Manshu

    Actually, I don’t think its that hard at all for small investors to make a decent bit of money in the markets at all. All it needs is a little discipline and an ability to ignore most of the news.

  • http://onemint.com Manshu

    Actually, I don’t think its that hard at all for small investors to make a decent bit of money in the markets at all. All it needs is a little discipline and an ability to ignore most of the news.

  • http://investoralist.com Dana

    Christian,

    Thanks for dropping by and commenting :)

    I think small investors have trouble sifting through the mountain of information, like you said, have trouble keeping up with what’s going on after their jobs.

    The problem I have with this is that too many small investors are over-invested in the market. Top flight mangers or not will most likely come up with pretty similar ideas when it comes to where the money can go – there are only so many markets, so many classes and so many investment groups.

    But they will probably give more personalized advice on how money should be allocated depending one’s portfolio and cash flow obligations (a portfolio made up of more than cash and stock market/mutual fund holdings – physical assets, real estate, art, etc) . They may also carry out more unconventional trades that are unpalatable to the small investors in order to recover if the market disappoints: i.e. work with options and warrants, going short.

    I’m not sure most easily accessible funds and walk-in financial advisors would provide that kind of service.

  • http://investoralist.com Dana

    Christian,

    Thanks for dropping by and commenting :)

    I think small investors have trouble sifting through the mountain of information, like you said, have trouble keeping up with what’s going on after their jobs.

    The problem I have with this is that too many small investors are over-invested in the market. Top flight mangers or not will most likely come up with pretty similar ideas when it comes to where the money can go – there are only so many markets, so many classes and so many investment groups.

    But they will probably give more personalized advice on how money should be allocated depending one’s portfolio and cash flow obligations (a portfolio made up of more than cash and stock market/mutual fund holdings – physical assets, real estate, art, etc) . They may also carry out more unconventional trades that are unpalatable to the small investors in order to recover if the market disappoints: i.e. work with options and warrants, going short.

    I’m not sure most easily accessible funds and walk-in financial advisors would provide that kind of service.

  • http://investoralist.com Dana

    Manshu,

    I know of two people close to me that are able to do this on a consistent basis – over a 10-15 year horizon. Perhaps you are the third? In that case, you are the minority. Most people do not have the knowledge, nor the time, nor the mental fortitude to handle what the market throws at them on a daily, monthly, or yearly basis.

  • http://investoralist.com Dana

    Manshu,

    I know of two people close to me that are able to do this on a consistent basis – over a 10-15 year horizon. Perhaps you are the third? In that case, you are the minority. Most people do not have the knowledge, nor the time, nor the mental fortitude to handle what the market throws at them on a daily, monthly, or yearly basis.

  • Skydaemon

    A decent article on the small investor.

    Most working stiffs have no concept of what the market actually is or what kind of volatility is possible there. They think it’s the difference between gaining or losing 4% in a given year, and could not conceive of the possibility of losing 30% in a year prior to now.

    I really think that society would benefit from teaching mandatory market analysis and stock trading in high school. Not only would they emerge capable of having a financial discussion without needing crayons, but they’d learn an immense amount about how the world is interconnected and actually works. This would help them evaluate not only investment and business decisions, but politics and social policy as well. Our nation as a whole would be better able to make rational choices rather than pandering to the beliefs of people that don’t know what is going on.

    The way it is now, any attempt to teach an average joe about markets, is more likely to scare them away unnecessarily than it is to help them. You’d be changing their whole worldview, not just teaching a single topic.

    Cookie cutter buy-and-hold and diversify advice is probably the best you can do for someone who is financially illiterate, unwilling to learn or pay attention, and both adverse to risk and uninformed about the nature of risk they are actually stepping into.

    Try to come up with any advice you can give someone else that will work no matter what the circumstances or market conditions are like, doesn’t require much learning, and can handle probably getting the timing/entry price wrong. The problem with almost any strategy is that at some point it will change or cease to be valid, or even worse, depends on competent execution.

    If you sat a top flight manager beside a regular investor, it wouldn’t produce useful advice. I suppose it could be possible to have a very competent advisor do a partial job, and instead of looking for the best returns, just created a path suitable for “bus turn” investment in some kind of vague sector rotation style or something. The issue there, is anyone good enough to do that is also good enough to give more accurate advice producing better results (but requiring competent execution). Most top investors don’t waste their day thinking about how to guide somebody’s grandmother through the market intact, so they probably would not have any advice to give an average investor without having to do even more work on top of their own.

  • Skydaemon

    A decent article on the small investor.

    Most working stiffs have no concept of what the market actually is or what kind of volatility is possible there. They think it’s the difference between gaining or losing 4% in a given year, and could not conceive of the possibility of losing 30% in a year prior to now.

    I really think that society would benefit from teaching mandatory market analysis and stock trading in high school. Not only would they emerge capable of having a financial discussion without needing crayons, but they’d learn an immense amount about how the world is interconnected and actually works. This would help them evaluate not only investment and business decisions, but politics and social policy as well. Our nation as a whole would be better able to make rational choices rather than pandering to the beliefs of people that don’t know what is going on.

    The way it is now, any attempt to teach an average joe about markets, is more likely to scare them away unnecessarily than it is to help them. You’d be changing their whole worldview, not just teaching a single topic.

    Cookie cutter buy-and-hold and diversify advice is probably the best you can do for someone who is financially illiterate, unwilling to learn or pay attention, and both adverse to risk and uninformed about the nature of risk they are actually stepping into.

    Try to come up with any advice you can give someone else that will work no matter what the circumstances or market conditions are like, doesn’t require much learning, and can handle probably getting the timing/entry price wrong. The problem with almost any strategy is that at some point it will change or cease to be valid, or even worse, depends on competent execution.

    If you sat a top flight manager beside a regular investor, it wouldn’t produce useful advice. I suppose it could be possible to have a very competent advisor do a partial job, and instead of looking for the best returns, just created a path suitable for “bus turn” investment in some kind of vague sector rotation style or something. The issue there, is anyone good enough to do that is also good enough to give more accurate advice producing better results (but requiring competent execution). Most top investors don’t waste their day thinking about how to guide somebody’s grandmother through the market intact, so they probably would not have any advice to give an average investor without having to do even more work on top of their own.

  • http://www.ockhamresearch.com Christian Ward

    Skydaemon 05.01.09 at 5:37 pm

    Love your thoughts, particularly surrounding basic investing classes for high school students. It is a shame that most kids graduate high school (and often times, college) without an understanding of what to do with their savings, and how to protect it or grow it.

    It is also a shame that the institutions such as exchanges, S.R.O.’s, and other regulatory authorities have not worked to make better access available to individuals to learn about investing. Many young people I speak with have credit cards, but few have money markets or basic ETF’s or any other investment instrument. So we teach them how to borrow, but not how to invest.

    It’s sad.

  • http://www.ockhamresearch.com Christian Ward

    Skydaemon 05.01.09 at 5:37 pm

    Love your thoughts, particularly surrounding basic investing classes for high school students. It is a shame that most kids graduate high school (and often times, college) without an understanding of what to do with their savings, and how to protect it or grow it.

    It is also a shame that the institutions such as exchanges, S.R.O.’s, and other regulatory authorities have not worked to make better access available to individuals to learn about investing. Many young people I speak with have credit cards, but few have money markets or basic ETF’s or any other investment instrument. So we teach them how to borrow, but not how to invest.

    It’s sad.

  • kevinrussellersel

    your ideas for saving are good advice… fine practices for all. however you are mistaking good fortune as being the result of hard work and good planning only. there is also an element of chance in your results. picture a world where all citizens had equal intelect, enrgy, desire… fidelity 401k everything equal. there would still be the same number of people at the bottom of society as today! the only way up would be for somebody else to fall down and allow you to take their better place in society. do you really believe everybody who has less than you has earned their reward?

  • kevinrussellersel

    your ideas for saving are good advice… fine practices for all. however you are mistaking good fortune as being the result of hard work and good planning only. there is also an element of chance in your results. picture a world where all citizens had equal intelect, enrgy, desire… fidelity 401k everything equal. there would still be the same number of people at the bottom of society as today! the only way up would be for somebody else to fall down and allow you to take their better place in society. do you really believe everybody who has less than you has earned their reward?