Is your self confidence waning? Do you feel you may be better off putting your money in a mutual fund and leaving stock selection to the fund’s professional managers? You should give the idea more thought. There are factors that hamstring the pros that don’t apply to individual investors.
Size can be a major drawback. When managers of big funds buy shares, they broadcast their interest to the market. The same thing happens in reverse when they sell. This means that fund managers usually drive the price up as they buy and push it down as they sell, thereby partly defeating their own purposes. Most individual investors, by contrast, have little effect on the prices of stocks they buy and sell.
The size drawback is even worse with small stocks. This keeps many pros out of such firms, even if they’re doing well. Individual investors can trade small stocks without much impact on their prices.
Keeping a job by following the crowd
Then, too, fund managers make decisions knowing that the directors will fire them if they can’t justify their mistakes. Sometimes this leads fund managers to mimic the choices of their colleagues, instead of following their own judgment. That way, if they make a mistake, they can argue that most other fund managers made it as well. Usually an individual investor has only his or her spouse to answer to.
Another stumbling block for fund managers is the prudent man rule. In modern times, this means investing little in any given stock. This often forces fund managers to invest in many stocks they know vaguely, instead of in a few they know well. Also, winners will have less impact on a large portfolio.
When a fund manager has beaten the market early in the year, he or she may become a ‘closet indexer’. That is, they then buy the market. This way they’re guaranteed to beat the market for the full year and earn a bonus for doing so. If they keep trying to beat the market, they put that bonus at risk.
Finally, some fund managers tend to pay little attention to their turnover ratios, or TRs. Studies show that funds with strong long-term returns have low TRs. That’s partly why studies of the biggest funds show that, in general, they underperform broadly-based stock market averages.
What your TR tells you
It always pays to know your ‘turnover ratio’, or TR. This is the extent to which you ‘turn over’ the funds in your portfolio in a year—how much buying and selling you do.
You can calculate it in a variety of ways. Our favorite is to add up the value of stocks you bought and stocks you sold in the course of a year, and divide by two. Then, divide your answer by the total funds in your portfolio at year end. That gives you your turnover ratio.
Successful investors often have an average turnover ratio of 20 per cent or so. In other words, they stick with an investment about five years on average. Less successful investors seem to have higher ratios. They do more buying and selling, and make less money.
Some aggressive investors buy and sell a great deal because they use discount brokers, so fees are minimal. Maybe so, but they still add up. You also have to consider ‘slippage’—you usually pay the ‘ask’ price to buy, and receive the ‘bid’ when you sell. The bid-ask spread is often high for stocks that trade little. You can avoid losing money to slippage by setting your own buy and sell price. The trouble here is that this can filter out some of your best investment decisions. Then, too, you may face capital gains taxes if you do make money.
Mind you, successful investors don’t stick with mistakes simply to hold down their turnover ratios. They reduce the need to sell by choosing investments carefully. Do that and your turnover ratio will take care of itself.
Use common sense and be patient
Our own experience over the years suggests that those who apply common sense, patience and a layman’s knowledge of business to their investments will do better than average. Those who invest haphazardly, by contrast will usually get poor results.
We’re not saying it’s easy to get rich in the market. But we feel it’s within the grasp of the average person to do well, if he or she takes a long-term approach and puts a little time into choosing investments. Where mutual funds offer more value is when it comes to investing in specialized sectors of the market, such as tech or emerging-market stocks.
The Investment Reporter, MPL Communications Inc.
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