How can a small investor beat a professional at his own game

If you are a small fish (as I am) in a sea full of business sharks, investing can be intimidating.

In all the financial markets there are smart guys who have access to huge amount of high quality data, they are almost insiders in many listed companies or have unrestricted access to the management.

Not only that, they basically spend eight hours a day, if not more, thinking how they can make a lot of money.

Competing like them feels like being a couch potato which decides to challenge LeBron James to a basketball game.

Yet, even if it looks it doesn’t make any sense, small investors have at least 2 possibilities to do better than active managers.

Let’s start from the easy one:

1. Choose your champion: Index Funds or some ETFs tracking broad indexes

Even if the money managers are spending a huge lot of time studying and investing, their performance (on aggregate) is not that great.

In this very detailed research published by Standard&Poor, it turns out that over the last 15 years, 92.2% of large-cap funds lagged a simple S&P 500 index fund. The percentages of mid-cap and small-cap funds lagging their benchmarks were even higher: 95.4% and 93.2%, respectively.

Basically, over 15 years almost no active money manager did better than the most representative US stock index.

Here is a table with more data:

Source: CNBC

Picking a great money manager (such as the legendary Lynch or Buffett) is even more difficult than picking stocks on your own.

So, as a small investor, if you want to beat the market you can just choose to be the market, buying an index fund.

An index fund is a fund which passively replicates a stock index of your choice for an incredibly small fraction of the cost, usually between 0.05% and 0.70% against costs that can be 2–2.5% for an active manage found.

So, buying one and sitting on your ass or doing whatever you feel like it’s enough to beat most of the active money managers around.

Congratulations!

This could be actually the end of this post, but what if you still feel like challenging yourself and investing your money in individual stocks without a money manager.

From the picture that I painted above, it looks like it’s a crazy idea.

Not even the smartest professionals can beat the market, how can you have a shot at this being a not professional investor and doing some research part time?

Well, turns out that you have some chances, if you know how to play the game.

2. Beat the pros…at another game

You can’t beat a professional investor at his own game.

But one of the beautiful things about the stock market is that you can play different games in one single place.

So, if you want to beat a professional investor you need to understand how he is playing, and how he has to play.

For example, a professional investor has a very small time frame during which he can make money.

Money managers need to make money…yesterday. They usually work on very short time frames (3 months to 1 year maximum) and they are frantically scanning the market for highly volatile situations which can be turned into opportunities.

They do that because their investors are impatient and want to get fast return asap.

“You don’t make enough money this quarter? We will just move our money to the next mutual fund which had a better return.”

That’s the constant pressure a money manager has to live with.

As a consequence, plenty of these professional will do more trading than investing, and they will sacrifice long term perspective for a quick buck.

So, the first strategy you need to adopt to beat a professional is to adopt a long term perspective, from 5 or 10 years minimum.

You will invest in the stock market only the amount of money that you can leave untouched, regardless of the fluctuations that will happen within this time frame.

This is giving you an additional advantage.

If a huge drop (more than 20%) in the prices should happen, a lot of people investing in active managed funds will panic, and they will ask for their money back, forcing the investment manager to sell stocks he doesn’t want.

Even if he knows that he should behave in the opposite way, he cannot do that because he is managing other people money and not he is not an independent investor.

If you are a small investor dealing with your own money, instead, you could start building some dry powder in cash and wait for the next big correction to happen and scoop plenty of good deals.

Apart from the different time horizon, there is another characteristic that can give a small and independent investor a huge advantage over a money manager: lack of costrains.

A lot of mutual funds invest in a specific category of stocks. Large cap, utilities, only US stocks, etc. and they are forced to do so. It’s written in the fund prospectus, and they cannot do otherwise.

It may look like it makes sense: after all, somebody can develop a lot of experience in this specific sector, and use it to find better deals.

But what will happen if the entire sector in getting overvalued and there are no good deals, or it looks like there are better deals somewhere else?

In this case, the money manager is forced (again) to make not the best choices he could, but just stick with the limitations he has written in the contract.

To use again the basket metaphor, it’s like playing 1–2–1 with Lebron James, but he has always to choose the right side, can’t dunk and in random moments he has to stop and give the ball back to you.

Oh, and if he fails 2 shots in row he lost.

Stopping him is still difficult (you need some basic basketball training and be in a good shape), but for some of us it can be at least possible.

The constrains can also appear in another form: the dimension of the company they can invest.

The best money managers work for big mutual funds, and they will not be able to buy a lot of small but promising companies.

Why?

If a company as a capitalization of 100 Millions of dollars, the only way for the fund to profit it significantly would be to buy it out (mutual funds have tens of billions to put to work).

But once the money manager buys it, it becomes an illiquid asset and it cannot be sold fast. Moreover, you will need to spend time making business decisions for a sector you know nothing about and putting extra people on your payroll.

All for something that will probably bring 0.05% of the profits of the fund.

To put it simply, it’s not worth the effort.

But if you are a small investor, you don’t have billions to put at work, you have thousands of dollars at best, and that’s opening up a lot of interesting opportunities not accessible to the money managers.

And small companies can do very well.

Finding the good ones is not easy (that’s the part where some accounting training/stock picking training will be helpful), but as long as you stay away from penny stocks and you keep under control the transaction costs, you have a good chance to do better than the professional money managers.

If you want to know more about which are the best ETFs or how to choose great stocks, have a look at my Facebook group where I share tips and discuss about the best strategies to use to be a successful investor.

And if you really hate Facebook, you can always reach me out with a message ;)