Tag Archives: Individual Investing

Individual vs. Institutional Investing

As an individual, it is important to know where you stand as an investor.  To succeed, you need to know your goals.  For most individual investors, their goal is to be able to fund their retirement expenses or even to be able to retire early.  Other goals might be paying for a child’s education, starting a business, or building a dream house.

To reach those goals, there is a simple path for an investor to follow:

  •       Earn a reasonably priced college degree that will lead to a high paying profession
  •       Limit debt
  •       Live below your means
  •       Max out your 401K and Roth IRA
  •       Invest in low-cost mutual funds that meet your age and risk tolerance

That is the basic formula for an individual investor to succeed.  It is easy, however, for an individual investor to stray from these simple steps.  It does not just occur.  The marketers who work for the financial industry muddy this simple message.  They tell you that being average is for losers.  To succeed as an investor, you must do hours of research and trade like a professional stock picker.  If that message sounds too overwhelming, the next best thing that they can offer you is a commission based financial advisor who will sell you overpriced mutual funds or an annuity that will more than likely underperform the S&P 500.

Know Your Competition

Despite most people having a 401K that holds stock and bond mutual funds, individual investors do not control the stock market.  As recently as the 1970’s the majority of trades were conducted by individual investors.  People would follow the performance of their stocks by reading the investing section of the newspaper and call in trades to their stockbroker.

Those days are long gone.  People no longer track their investments in the newspaper.  They now use online investing platforms.  They also no longer control the volume of trades.  Today, almost 95% of the trades are performed by institutional investors.

Scale

If an individual decides to try to invest as an institution does, they are trying to compete with institutional investors.  Individual investors do not possess the resources that institutions possess.  Individual investors lack the scale that institutional investors have.  They have access to investments that non-accredited investors do not have.  Large institutions such as Pension funds, university endowments, foundations, and fund managers have billions of dollars in assets under management.

Institutional investors employ teams of professional investors who have attended the best Ivy League Universities and business schools.  Only the best and the brightest are hired to manage these large pools of assets.  They hire teams of professional investors who are experts in specific markets.  It is beyond a David vs Goliath comparison to compare the resources of an individual investor to an institutional investor.  The individual investor is simply out of their league.

Information

When an individual investor buys shares of a security, that purchase is not just an exchange of money for shares of a publicly traded company.  It is a statement.  The trade can be interrupted to mean that the investor knows that the stock is undervalued.  It is not correctly priced in relation to the market.  It is a vote of confidence that they know more than what the entire financial industry knows about that stock.  The individual investor knows that the company has the management, financials, and potential for revenue that nobody else is aware of at that moment.

Odds are, the individual investor does not know anything that the whole world already does not know.  Individual investors are actually the last ones to know.  The first ones to obtain the facts about management, financial statements, and the potential for growth of a company are the industry experts, insiders, professional analysts, and then the financial media.  Unless you have insider information, you are getting your information from the financial media.  At that point, the price of the security is priced based on its business fundamentals and potential for growth.

Analysis

The stock market is efficient over the long term.  Yes, an individual investor can occasionally find an undervalued stock.  When that does occur, it is more than likely the result of luck than analysis.

Most individual investors do not have the education or analytical training to properly research securities.  They also do not have the time if they already have a full-time job.  Yes, the commercials for trading platforms state that anyone can do it, but it is just not true.  If it were true, individual investors would not underperform the market the way that they generally do.

When there are rare buying opportunities like the fall of 2008, most individual investors do not take advantage of this buying opportunity when almost the whole stock market goes on sale.  Rarely do individual investors have the courage to go against the grain and buy when the world is selling.  When these opportunities do become available, most individuals are selling low and waiting on the sideline to buy when the prices increase.

It is a better practice for individual investors to let professional financial analysts try to analyze hundreds of companies to find the best stocks to invest in.  They get paid to try to outperform the S&P 500.  Over the long haul, most of them fail too.  If institutional investors with almost unlimited resources and talent cannot consistently beat the market, what chance does an individual investor have?

Time

For an individual to be a successful investor, they must invest for the long term.  Dollar-cost-averaging, rebalancing, and compound interest are the tools that will drive the success for the individual investor.  By dollar-cost-averaging a fixed amount into a 401K, an investor will get to purchase stocks when they are priced both high and low and capture the average price and return.  That along with holding those stocks for decades will allow for compound interest to work.

For example, let’s examine the performance of a portfolio composed of 60% in the S&P 500 and 40% in The Total Bond Fund that was rebalanced annually.  How did this portfolio perform 1996 to 2016?   If an individual investor invested $500 per month into this balanced portfolio that portfolio would have averaged a return of 7.4% per year.  That portfolio would have grown to $192,000.

This is where the individual investor has an advantage over the institutional investor.  The institutional investor must work to beat the S&P 500 or whatever benchmark they are compared to depending on the type of securities they invest in.  The advantage that the individual investor has is that they just have to capture the market average that the index produces.  The fund manager is highly compensated for short-term performance.  If the fund manager does not perform, they will be replaced.  If the fund continues to underperform, they normally merge with another fund.  It is getting harder and harder for professional investors to beat the market due to the Shrinking Alpha.  Based on the data provided by SPIVA, Over the past 10 and 15 years, only 18% of domestic funds outperformed the S&P 500.

By focusing on being average, time is the ally of the individual investor.  The individual investor does not have to get bogged down with quarterly earnings reports or making a second career out of managing their investment portfolio.  There will be positive and negative quarters.  When there are negative quarters, it is a time to buy low.  When there is a positive quarter, it is still a time to buy, but also a time to watch those low-priced shares that were purchased grow in value.

Conclusion

Be true to yourself.  Know your strengths and limitations.  If you are not David Swenson, Bill Gross, Peter Lynch, or Bill Miller, you should not try to replicate how they invest.  How they invest is not useful to you.

Establish your goals.  Write a financial plan.  Identify what you want to achieve and experience.  What are you saving for?  How do you plan on using your money to improve your life and the lives of others?

If you are not a professional investor, stop pretending.  Stop trying to time the market.  You are just buying high and selling low.  You are wasting time, energy, and money.

Stick to the basics.  Establish what your risk tolerance is as an investor.  How much of a loss can you tolerate before you sell low? When will you need the money that you are saving/investing?  A good place to start is with a balanced portfolio of stocks and bonds.  If you are in your 20’s, you might want to allocate more in stocks.  If you are in your 50’s, you should probably consider holding less in stocks if you are retiring soon.  After that, let dollar-cost-averaging, rebalancing, and compound interest work for you.

This post might contain affiliate links.

Always consult with a financial professional before making an investment decision.

Please be sure to read the Disclaimer Page.