Individual investors like you and me have one distinct advantage over the “smart money” institutional investors.
It’s not information. The professionals have expensive Bloomberg terminals or the like, feeding them real-time news that might move the markets. They can access a particular company’s historical financials, growth rates, multiples, stock price history – all in a few keystrokes. They can get company management on the phone to ask questions about strategy, tactics and results. Many institutional investors have in-house economists with PhDs, who forecast the future.
It’s not technology. Professionals use high-frequency trading to gain an edge with speed, or they try using wildly complex algorithms that predict short-term stock price movements with uncanny accuracy.
Your and my primary (if not only) advantage over the professionals is time.
You see, most professional investors on the “buy side” – those actually managing money – have to regularly validate their existence by beating their benchmarks. “Since inception” returns are great, fund holders seem to say, but what have you done for me over the past 12 months?
Mutual fund money flows out of funds that’ve performed poorly and into funds that’ve performed well. This phenomenon is so well-established that it has a name: performance chasing.
“Sell side” analysts, who write and distribute research reports on companies and sectors that are bought by the buy side, are judged on whether their calls (“Buy,” “Hold,” “Sell”) are correct over relatively short time periods. They’re paid well, but it’s a high-stress game.
Individual investors, on the other hand, don’t have to worry about redemption requests from our fund holders, or the professional embarrassment of making a bad stock prediction. We can buy shares and… well, do nothing. We can let them sit in our portfolio as long as we want, with no one to answer to, except perhaps our spouses. (Ok, we all definitely have to answer to our spouses!)
Morgan Housel, a Fool of yesteryear, illustrated it like this:
The chart shows the percentage odds that a given holding period would yield a positive return. The grey zone is where institutions typically have to hang out. From a historical perspective, the odds were slightly better than a coin flip that their required holding periods would’ve yielded a positive return from the S&P 500.
You and me, on the other hand, hang out in the green. We can let our money compound for years – or even decades. And judging by U.S. market history, the longer we can let time work its magic, the better our chances of making money become.
Motley Fool Singapore senior analyst Chong Ser Jing has showed a similar pattern locally: Measuring returns at the start of every month from 1988 to August 2013, if the [Straits Times] index was held for a year, there’s a 41% chance of sitting on negative nominal (i.e. unadjusted for inflation) returns. Hold it for 10 years, and losses occurred only 19% of the time. Double the holding period to 20 years, however – here comes the kicker – and there were no losses.
I got to thinking about this point after reading an article about university endowments over the weekend. In theory, university endowments should be the exception to the rule – endowments are institutional investors, but they ought to have an even longer time horizon than us! After all, Harvard University, or the NUS, are investing for the next century… and beyond. And yet, even those institutional investors who SHOULD have the longest investment outlook don’t. And the reason why is instructive.
A recent column by the investment writer Roger Lowenstein explains why: The reason institutions with access to the biggest brains in America rack up such mediocre marks is that they suffer from an obsessive desire to avoid volatility. This makes sense over the short term. The money you will need next year shouldn’t be subject to the ups and downs of the market. But the overwhelming portion of what universities invest is for the distant future. Indeed, no one has a longer horizon than they.
Here’s where things go sideways. The “obsessive desire to avoid volatility” means endowments load up on so-called alternative strategies. Think real estate and hedge funds.
Not too long ago, the average American university endowment had a stunning 52% of its portfolio in alternatives, which typically charge high fees. Their attraction lies in the promise that they’re not correlated with the market – that is, they reduce volatility.
Lowenstein shows the folly in so doing: Endowments that indiscriminately follow such strategies are foregoing their singular advantage – the freedom to take a long view – for the privilege of letting their trustees sleep a little easier during periods such as now, when the market is unsettled.
Volatility is the price you pay for long-run investing returns. Embrace that fact, don’t run away from it – because a long time horizon is our #1 investing advantage.