Friday, February 8, 2013

Individual Investors Do Stand a Chance

It is understandable that many individual investors have given up on investing in the stock market.  The Wall Street crowd has gotten rich over the years, while their clients often were left holding hyped investments that rose amid euphoric markets, but which fell sharply when more sober judgments prevailed.  After the stock market collapses from 2000-2002 and again from 2007 to March 2009, who can blame individuals for looking elsewhere for investment opportunities.  After the financial collapse of 2008, individuals have withdrawn several hundred billion dollars from equity mutual funds.

But individual investors should not give up, as they do indeed have a chance to earn respectable returns.  The media are filled with advice and forecasts from economists, investment strategists, security analysts, and fund managers.   But when it comes to investing, the forecasts rarely work out.  Investors are usually better off going contrary to the conventional wisdom.  After all, in order to "buy low and sell high," one must go against the popular mood--even among the supposed experts--since, when the mood is gloomy current conditions are bad (but assets are depressed in price and are cheap).  Conversely, when the mood is euphoric current conditions are good (but assets have already risen sharply in price and are consequently expensive).  Starting price matters in investing.

Entering a market that is expensive leaves poor odds for success, and entering a depressed market leaves much better odds and a margin for error (some say "margin of safety").  It's like trying to swim down a river that has a current of 10 miles per hour.  When one buys into a market that is historically cheap (undervalued) or is out of favor, it is like having the current at your back.  It would be easy for most of us to float down the river with the 10-mile-per-hour current at our backs.  If, however, one buys into a market that is historically expensive (overvalued), it is like trying to swim against the current of 10 miles per hour.  Not many of us would be able to make progress against such a stiff current.

One of this era's most esteemed investors, Warren Buffett, has said that individuals don't need superior intelligence to be good investors.  They instead need superior temperament, specifically the ability to go against the crowd and to be patient.  He has likened investing in stocks to being at the plate in baseball but not having any strikes being called.  Under such conditions, the batter can wait until a "fat pitch" crosses the plate before swinging.

The antithesis of the individual investor is probably the hedge fund investor.  Hedge funds are unconstrained funds run by supposedly the most savvy investors in the business.  Some, such as Bridgewater Associates, have tremendous long-term returns.  But like with mutual funds, most have only pedestrian returns and are not worth the high fees that are charged.

What happened to these purported masters of the investment universe?  In 2012, hedge funds on average returned only 6.7%, versus 17% for global stock markets (the MSCI All-Country World Index).  In the U.S., the S & P 500 returned 16%.  This was the fifth time in the last seven years that hedge funds have trailed major stock market indexes.  It is true that hedge funds don't invest in just stocks, so that might be an unfair comparison.  But an investor who simply used stock and bond index funds last year in a 60% stock index/40% bond index portfolio, would have returned 12%, nearly double the return generated by the average hedge fund.

Goldman Sachs estimates that the average hedge fund return over the next five years will be only 4-5% per year.  Given that and the historic record of hedge funds, why have the richest individuals and many endowment and pension funds invested so much money in hedge funds, which have total assets of $2.2 trillion?  

I used the 60% stocks/40% bonds example to make a point.  But I do not endorse the practice of having a fixed allocation among stocks, bonds, and other assets at all times.  It makes no sense to have a fixed percentage in stocks, regardless of whether stocks are historically cheap or expensive.  (Remember the analogy of swimming down a river.)  

That doesn't mean that one needs to be a market timer either.  Just pay general attention to the prevailing mood (market sentiment), whether markets are depressed in price or "frothy" after an extended rise in price, and whether the investment is cheap or expensive (based on e.g.,  its dividend yield or earnings multiple) versus its history.

And forget about the expert forecasts.

Steve Lehman