Baruch at Ultimi Barbarorum has sparked a debate in the blogosphere about whether the average guy should invest on his own. The detractors, such as David Merkel at the Aleph blog, say that investing is hard and not for amateurs (although I should point out that Merkel’s mother is apparently an excellent amateur investor, as is Merkel himself). In this debate, unsurprisingly, I am on the side of Baruch. I could cite my own investment record, and probably many of my readers could cite their own outperformance as well, but I have a much more compelling argument. A regular Joe has no appealing options when outsourcing portfolio management. If you don’t invest on your own, you’re basically doomed to underperformance.
First, let’s look at the most popular way to outsource portfolio management, the good-old mutual fund. Numerous studies show that the vast majority of mutual funds underperform, with only a teeny tiny proportion of the funds outperforming. Certainly, the funds that outperform are not the ones you see on television and magazine ads. You’ll be hard pressed to find these outperforming funds. Recent outperformance and Morningstar ratings are most assuredly not the way to find good funds. Most funds are primarily interested in asset gathering and not performance. My advice is to shun all mutual funds. They are the chumps that other market participants feed on.
Then, there are the index funds, many easily available as ETFs. Index funds are less bad. They have low expenses, but are susceptible to front running strategies. So basically, you’ll still underperform the market, but not by much. This can be an acceptable option for those who really hate reading and numbers and want to put zero time into research.
Hedge funds and investment partnerships are better, because the 20+2 compensation structure aligns the interests of the management and investors. A larger percentage of hedge funds outperform the market compared to mutual funds. But the point is moot, since the SEC in its infinite wisdom has deemed these investment vehicles off-limits to the general public. And in any event, the minimum investment for these vehicles is stratospheric. Hedge fund managers have only 99 slots to fill before they become mutual funds and have to be regulated by the SEC, so understandably, they require enormous minimum investments.
Then there is a passive investing approach for those who is willing to spend a little time reading, but don’t want to crunch financial reports. This is my preferred passive investing approach. That is, to look for situations where the management has a huge stake in same investment vehicle that the public has access to, and therefore can be counted on to be a responsible steward of the investment. Fairholme Funds, Microsoft, Berkshire Hathaway, and Apple are several names that come to mind. With a modest amount of research, you can acquire a diversified portfolio of such names, which is likely to outperform the market if held for a period of years.
At the end of the day, by definition, some segment of the population must underperform the market. Like at the poker table, if you don’t know who the patsy is, you’re the patsy. If you’re okay with underperformance, then so be it. If you have only modest sums to invest, then the time spent in thinking about investments may be better spent enjoying your life and your work. But I believe that if you actually enjoy stock picking and watching your investments grow, and if you are willing to put in 5-10 hrs weekly on research, there are reasons why a retail investor may indeed outperform Wall Street professionals, which I’ll touch on in my next post.