How on earth are we supposed to outsmart professional investors? Mutual fund managers control over 85 percent of the money in the stock market; they live and breathe stocks, so we don’t seem to have a realistic chance. Isn’t it better to simply invest in a low-cost index fund? I get this question in various forms every single month, so I want to put this issue to bed once and for all with this writing.
Historical data unquestionably shows that something is seriously wrong with the fund management business. The overwhelming majority of mutual funds fail to beat the market with any consistency over time. That said, most actively managed funds are collecting enormous fees for a job they do not deliver.
This is common knowledge, yet most people draw wrong conclusions from the factual data.
They think that even the full-time pros are not good enough to produce investment returns that exceed the market average consistently. This is not true. The reasons for failure are twofold, with high fees that drag down the investment performance being the first and short-termism of the entire industry the second. Active investing does work! But not the way most fund managers are forced to do it.
“In fact, the amateur investor has numerous built-in advantages that, if exploited, should result in his or her outperforming the experts, and also the market in general.” (Peter Lynch)
Peter Lynch was one of the most successful fund managers of all time, so he does know a thing or two about that business. When he talks, we all should listen!
Recently, I’ve had lunch with two European fund managers, and quoting some parts of our conversation may highlight the advantages we, as small investors, clearly have over the pros. It shocked me when one of these guys said:
“Whenever I get in the office, my colleagues tease me about the most recent price movements of the stocks in my fund’s portfolio. Short-term performance is everything. My bonus and, basically, my survival depends on it. This job involves extreme pressure.”
Both know the logic behind the FALCON Method, and the other guy added:
“You are lucky that you can invest the way you do. I would do that with my own money as well. You have the luxury to ignore the short-term noise or even profit from it while we cannot afford to make sensible long-term decisions without the risk of getting fired before those decisions could bear fruit.”
These fund managers do have the proper knowledge to achieve superior investment performance, but the system is not built to suit them. (Or any thoughtful long-term investor, for that matter.)
The fund management industry is all about making you believe that you cannot manage your money on your own. They earn billions from commissions and fees as long as they can do this. The one thing to understand, though, is that you don’t have to be smarter than the pros on Wall Street; you just have to play by a different set of rules!
Have you ever thought about how different meanings a steep price drop could have depending on your timeframe? Fund managers follow the crowd. They have to. They cannot hold something that’s going down in price. It will make them look bad to their investors, and then they will eventually lose those investors along with their jobs. These guys are very bright, but have a different drummer to dance to. They are in the business of keeping their clients and gathering more assets to manage while you are in the business of making money for yourself. These two businesses can dictate very different responses to the exact same market situation!
Let me make this perfectly clear with a striking example. What if I offered you a $100 bill for $50? I hope you’d grab the chance. Then would you be upset about your decision to buy that first bill if I offered you another $100 for $25 the very next day? And would you freak out if I offered you a third $100 for $10 later? In fact, you should be excited to buy the first one, more excited to grab the second, and absolutely thrilled to get the third one. This is common sense as long as you are not judged on short-term performance. (Most fund managers, on the other hand, would sell out in such a situation by the time the third offer arrives, regardless of the value of the underlying $100 bills. They wouldn’t want this panic-stricken asset to show up in their quarterly statements causing investors to lose trust. After all, everyone knows that the price of “that thing” is falling like a rock; who in his right mind would hold it in their portfolio? And with this, even the most apparent value considerations get thrown out as managing career risk prevails. Take some time to think about this!)
As an amateur investor, would you be nervous about the price of your asset dropping that steeply? Not with the $100 bill in our example, but somewhat more with a stock, I guess. The reason is simple: while you are totally sure about the value of the $100 bill (and are happy to get that value for a lower price), on some level, you still feel that the price has something to do with the value of the stock. Well, it doesn’t! Price is what you pay; value is what you get. As a do-it-yourself investor, you can play the difference between the wildly fluctuating stock price and the more stable intrinsic value of the underlying business. This is the luxury that fund managers crave as they live and die by the unpredictable price movements of the short term.
The real question is whether you can chill out when the fund managers controlling more than 85 percent of the market are freaking out. Knowledge and experience can give you the peace of mind to feel excited and not nervous when stock prices drop. In fact, I am grateful for every meaningful sell-off since I expect to be a net saver during the next 5-10 years. Many investors get this wrong. Even though they will be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall.
The point I wanted to drive home is that active investing does work as long as you are doing it yourself and don’t overpay for actively managed funds plagued by short-termism. As factual data proves, some of them might outperform but not by a wide enough margin to justify their fees.
However, the biggest advantage of the active approach is that you can tailor your investment strategy to your needs. For me, that means a healthy blend of income-producing dividend stocks and quality-growth beasts (we label EVA Monsters in the FALCON Method newsletter.)
Get to know more about our EVA Monster vs. Fallen Angel categorization from these insightful case studies.
Once you let short-term stock price fluctuations affect your mood and direct your decisions, you are playing the big guys’ game where they will crush you. As Warren Buffett said, Mr. Market should be your servant, not your guide. Play by different rules! Make the most of your built-in advantages (e.g., lack of career risk), keep buying those $100 bills for less than their true value, and wait patiently for the bipolar Mr. Market to take his medicine and recheck the price labels on your assets. You cannot go wrong with this strategy as long as you are patient and focus on the value of the underlying businesses instead of the stock market’s wild ride.
One final reality check. Could you go on a device-free holiday for a week without checking the market every day?
As for the stocks in our FALCON Portfolio, I could even go on a five-year trip around the world without internet access since I didn’t buy lottery tickets but partial ownership stakes in wonderful businesses that don’t require any activity on my part to produce more cash (and pay more dividends) by the end of my imaginary trip. You’ll need the same kind of conviction about your portfolio to stick with it when times get tough.
Take the first step today by learning more about our evidence-based stock selection process with this free report.