Can Individual Investors Consistently Outperform?
This post on biggest investors mistakes by the usually brilliant Jeff Miller at A Dash of Insight pushed my buttons. Jeff normally takes great care with his assertions and goes to great lengths to back them up with credible evidence, but in this case he leads off with an apples to oranges example.
Many studies have shown that individual investors, managing their own accounts, do about 5% worse than they would if simply buying an index fund. The top investment managers have regularly beaten the averages, so it is a big spread.
I commented
You’re comparing average investors with top managers. While I know that was merely an introduction and not central to your point, I found it incongruent from a guy who normally takes such care with his assertions. On top of which there is plenty of evidence to show that agency costs are a permanent feature of fund managers and as Patrick said that the average manager under-performs.
The average investor contains all investors. Do you know of any evidence that analyses experienced investors, say 10 years plus experience and accounts over say $300k, or any other figures?
Another commenter replied,
“CXO Advisory in March cited an SSRN paper that showed Chinese investors with large accounts (presumably more experienced) had higher returns than those with small accounts. The difference was quite significant, and apparently due to reasons that might be expected – buying value stocks and trading less frequently. They also have links to additional studies.”
I decided it was time to pull together some of the literature on individual investors.
Can Individual Investors Beat the Market?
We document strong persistence in the performance of trades of individual investors. The correlation of the risk-adjusted performance of an individual across sample periods is about 10 percent. Investors classified in the top performance decile in the first half of our sample subsequently outperform those in the bottom decile by about 8 percent per year. Strategies long in firms purchased by previously successful investors and short in firms purchased by previously unsuccessful investors earn abnormal returns of 5 basis points per day. These returns are not confined to small stocks nor to stocks in which the investors are likely to have inside information. Our results suggest that skillful individual investors exploit market inefficiencies to earn abnormal profits, above and beyond any profits available from well-known strategies based upon size, value, or momentum. read more
Wow! Not a bad starter, but let’s keep digging. If you know of any research highlighting how individual investors can outperform then please leave a comment.
In general individual investors tilt the scales in their favour by looking to exploit the excess returns offered by small caps, value stocks and momentum stocks. There is plethora of research on all three.
Momentum
Research into momentum in stocks shows stocks do exhibit positive momentum over 3 – 12 months. While over the longer term of multiple years a negative correlation is found, i.e. momentum stocks eventually fall back to the pack.
- Momentum studies like this, Momentum Strategies by Louis Chan, Narasimhan Jegadeesh and Josef Lakonishok, reveal how past earnings surprises predict large drifts in future returns as analysts and the market are slow to respond.
- Momentum Profits, Non-Normality Risks and the Business Cycle by Ana-Maria Fuertes, Joelle Miffre and Wooi Hou Tan. This paper show that momentum profits are not normally distributed and, relatedly, that the momentum profitability is partly a compensation for systematic negative skewness risk in line with market efficiency.
- For more on momentum.
I’ll post on value vs growth and small vs large caps in separate posts, but for anyone unfamiliar with the large body of evidence the basic story is both value and small caps have in the past outperformed growth and large caps by significant margins. I do mean to imply that all investors should manage their own investors. I actually believe the contrary, most investors should invest in index funds with long term perspectives, investing more when markets are historically undervalued and less when they are overvalued. Alternatively they should seek out small cap value focused fund managers with a record of outperformance. As with everything there are exceptions. Self directed investing takes a lot of time and skill and is an art that few truly master.
Advantages of Individual Investors over Institutions
The following is a quick incomplete list, primarily to get some thoughts down for further investigation.
- Jack be nimble jack be quick. Individual investors can react faster to opportunities and change their asset allocation much faster than institutions.
- Patience. Institutional imperatives force most funds into high turnover strategies. Individual investors can wait for fat pitches.
- Small caps outperform. Large institutions can’t take meaningful positions in small caps. Even small institutions find it hard to take meaningful positions in small caps without pushing the price up on entry and down on exit.
- Management costs. With active fund managers charging between 1-2.5% and sometime with an added 20% of excess returns, individual investors are given a head start.
- Agency costs. On top of fees are agency costs. Institutions’ primary aim is to make themselves money, while they’d like to make their investors money too, conflicts can and do arise.
- Flexible guidelines. Most funds are constrained by their strategies, which for the most part are designed to fit in with particular themes, e.g. large cap growth. Plus many are mandated to be 100% invested all the time. Talk about a handicap. Individual investors can invest in the best opportunities regardless of style, market cap or any other arbitrary restriction and they can move to cash when markets are overvalued.
- Comparison. Most funds ‘need’ to follow relative return investing styles. The smartest investors all say absolute returns should be focused on, with relative returns a mere point of interest. Individual investors can focus on their absolute returns without fear of being fired for underperforming.
In fairness, institutions have many advantages over individual investors, but as they also have large marketing departments I’m sure you;ve already heard their side of the story. Finally I in no way mean to slate Jeff Miller and encourage readers to add his blog, A Dash of Insight, to their regular reading list.
Related posts:
This is quite a confusing discussion.
If the question is, “can an individual investor beat the market?”, the answer is clearly yes. Yes from the point of view of pure statistics based on normal distribution, or even “fat tails” distribution. In normal parlance, some guy/gal will always get lucky.
If the question is, “can individual investors as a class beat the market?”, the answer is clearly no, because the implication of a “yes” answer will be that institutional investors as a class must perform below the market, given that both classes added together comprise the market.
The discussion needs to be reframed.
I suspect you are revisiting the hypothesis of whether EMH is true or false.
Hi Peter
Good point. I missed one word, regularly or perhaps consistently. I’ve updated the title to reflect that. Yes, some investors will beat the market by luck, even over long time frames, but as the referenced research show their is a strong correlation in returns suggesting some investors are more skilled and can regularly beat the market.
I now believe the question of whether EMH is true or not is nonsensical. The right question is how efficient is the market. As with almost everything there is no black and white, but shades of grey.
Great post at TMF on luck vs skill
Since TMFgebinr mentioned Maboussin in another thread, I thought the group might appreciate this paper I’ve seen circulated lately
always an interesting question and one I don’t think most investors ask enough.
reminds me of my old ball coach who used to tell us “the harder you work, the luckier you get”
Some lines of wisdom/insight I saw in the paper (there were lots)
“In the aggregate, institutional money tends to flow to assets that have done well and fails to consider sufficiently the role of luck.” page 2
“One point is worth making right upfront: the outcomes of any activity that combine skill and luck will exhibit reversion to the mean” page 3
“Outcomes that are highly persistent over time tend to be shaped more by skill than luck”
page 4
“Probably the single biggest challenge in assessing the relative contribution of skill and luck is that in most cases we can only observe outcomes.” page 6
“But the research also shows that only a small subset of the investing population is skillful, and that the percentage of funds that are skillful is declining.” page 16
“Corporate performance also shows reversion to the mean. This phenomenon has been well documented for decades.43 For a company, skill is equivalent to competitive advantage, which confers an ability to generate returns on capital in excess of the cost of capital. Companies, like athletes, tend to follow a lifecycle. A company typically sees its skill diminish as the industry matures, as all competitors move toward optimal efficiency, and as prices are set so that they squeeze out excess profits. Competitive advantage is closely linked to barriers to entry. Bruce Greenwald, an economist at Columbia University, is fond of saying, “In the long run, everything is
a toaster.” He picked the toaster to symbolize a mature, competitive business with no barriers to entry and no excess returns.” page 19
“Research by Robert Wiggins and Timothy Ruefli, professors of management, shows that not only is reversion to the mean in clear evidence for the corporate world, but also that returns are converging at a faster rate today than they did in the past.” page 20
“The sad fact is that there is significant evidence that investors—both individual and institutional—fail to recognize and reflect reversion to the mean in their decisions. To illustrate, the S&P 500 Index generated returns of 8.2 percent in the twenty years ended 2009. The average mutual fund saw returns of about 7 percent, reflecting the performance drag of fees. But the average investor earned a return of less than 6 percent, about two-thirds of the market’s return” page 21
“Christensen studied why great companies with smart managements and substantial resources consistently lost to “disruptors,” companies with simpler, cheaper, and inferior products. He describes two ways that this can happen. In one case, the disruptors introduce a product that is at the low end of the market and that is neither profitable for the incumbents nor in demand from the incumbent’s current customers. Incumbents are motivated to flee the low-end segment of the market and to focus on more value-added products. This becomes a problem as the disruptors improve their offering and move up market, eventually encroaching on the core business of the incumbent, and doing so with a lower cost structure.” page 23
“The central insight is that the more the outcomes of an activity rely on luck (or randomness), the more powerful reversion to the mean will be” page 24
Pages 25-27 were too excellent to cherry pick any segments out. I recommend reading those concluding pages in their entirety.
Good post. May be a handful of investors can beat the markets, by luck or skill. But investors as a class cannot do this.It is better for them to stick with an low-cost index fund.
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