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The Curse of Success(ful Investing)

May 7th, 2013 by 
PK

Is it true?  Is having less money to throw around and managing it on your own really an investment advantage?  Let's ask Warren Buffett:

"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that." - Warren Buffett

Younger, cockier Buffett succinctly said what many others have tried to impress upon investors - your smaller size is an advantage in the markets.  Call it the curse of success or whatever you want (and this isn't an article about mutual funds), but a little success in the markets can be a bad thing for a fund.  Consider this success spiral:

A basket of eggs with brown eggs inside... not an investment advantage

Yep, one egg basket. I'm so creative. Eggs don't provide an investment advantage. (Morgue File)

  1. Beat the market
  2. Attract tons of new investor money
  3. Fail to beat the market with the huge influx of cash
  4. Cash leaves
  5. Beat the market
  6. Repeat!

Too Much Money, Not Enough Opportunity

The fact that most mutual funds do not beat a standard benchmark, like, say, the S&P 500, leads a lot of people to believe that beating the market is an impossible goal.  We, of course, are a bit more sympathetic to the idea - but we do feel this game is rigged.  Remember, when you invest your money, you face many less restrictions than a mutual fund manager.

That's right - we hold our mutual fund managers up to a higher standard than ourselves.  Mutual fund managers have to:

  1. Hold some money in reserve due to redemptions
  2. Follow strict strategies laid out in a prospectus
  3. Hue to specific asset allocations (again, in the prospectus)
  4. Usually avoid purchasing controlling stakes
  5. Keep performing quarter after quarter

Watch that Basket!

Andrew Carnegie (supposedly) said something like, "The way to get rich is to put all your eggs in one basket and watch that basket."  That's right - diversification might cushion your downside, but it also requires you to be correct more times in order to have the same upside.  I'm being charitable here - unless you make multiple good calls, you're limiting your upside.  Most large fortunes have come from avoiding diversification - people staking their bets on one company, investing in one good stock, buying real estate in one city or region.

I'm not saying that the preponderance of evidence means you must become less diversified, I'm saying that if you feel that you have an edge, you won't realize it by buying hundreds of stocks, or investing billions of dollars of Other People's Money.  The reason that most people who read this article can theoretically beat a benchmark is because of their increased flexibility - you can buy small (and micro) capitalization stocks with most of your capital if you so choose, and you probably won't be buying a controlling stake.  If a mutual fund with billions of dollars tried it?  Their purchase would require disclosure to the SEC, would move the market noticeably, and they would still (in the case of some stocks) need to buy other companies.  Neither the mutual fund nor you are in the business of running companies, just investing in promising ones... so you can see where that would be a problem.

Where This Information Suggests You Look...

Draw a bunch of arrows from this information, and what do you see?  Mutual funds pretty much define the market... even if they are trailing indices or making formulaic purchases in portfolios of 50+ stocks (which behave like an index anyway), they aren't going to beat the market.  Remember, again, they have to both take out fees and keep money in reserve - so they will never even track an index perfectly.

What can you take from this?  Sure, it increases your risk - but to beat mutual funds (and, yes, the market if it is possible) the way to do it would be to employ strategies the mutual funds won't touch.  Whether than means leverage, small cap stocks, deep value stocks, turnaround plays, merger acquisition, options and futures, commodities, or something else is your call - but you can't beat them by joining them.  If you're going to try to beat the market, assuming you think it's possible - don't do it by emulating large mutual funds.

Coming Full Circle on the Investment Advantage

Buffett recently put a contrarian voice on the Berkshire Hathaway board to provide a counter-opinion to him and Charlie Munger.  The so-called perma-bear, Douglas Kass, recently asked if Berkshire was too big to employ it's old strategy.  He used colorful language - an "index fund" fit for "widows and orphans", where the company is so big it can only hunt elephants.

Buffett may be the exception to the rule, and might be the ultimate Big Game Hunter of the investment world.  Do you think you can compete?  If you don't, you know where to look for an investment advantage...

 

Don't Quit Your Day Job...

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