There are numerous studies that indicate that it is impossible to beat the market as an individual investor. Beating the market has been described as so difficult that only the best and brightest on Wall Street can do it.
So if that’s the case, who are the individual investors who believe they can pull off the miracle of outperforming the larger market? Funny right?
Maybe. But before you write off investing in individual stocks, there are some flaws in this argument to keep in mind that Wall Street doesn’t want you to know.
Using professionals as a benchmark for individuals is problematic because institutions have unique incentives that influence their trading behavior. The two main motivators are investor retention and performance-based bonuses.
In other words, fund managers need to generate strong returns every year because if they don’t, they’re likely to lose investors and make significantly less money on their year-end bonus.
They are powerful motivators for short-term gains. Meanwhile, individual investors are under no pressure to deliver instant results.
High turnover between funds
Ironically, after hearing that over 90% of fund managers are underperforming, investors should conclude that chasing short-term gains is disastrous for long-term performance.
The main reason is the high turnover. A turnover is a change in position within a portfolio. At The Motley Fool, we advocate low turnover so your companies can work together over the long term.
In 2019, Morningstar found that the average domestic stock fund returned 63%. In other words, from the beginning to the end of the year, the fund’s average holding fluctuated around 63%.
Consequences of high turnover
As fund managers look to short-term results, there is a very real long-term impact on their performance. The two main costs are the lack of compound interest and higher taxes due to short-term capital gains.
Compounding is a by-product of making great investments and should be every investor’s goal. Compounding occurs when you start earning interest. If you get a 10% return on a $1,000 investment, you’ll make more dollars each year as the overall portfolio grows. In the early years, the merger is difficult to notice, but after a few decades, the results are dramatic.
With the constant pressure to hunt hot stocks, very few fund managers get to enjoy this benefit. Herein lies the real benefit to you as an individual investor: you report to no one but yourself and aren’t pressured to chase hot stocks for short-term results.
In addition, high turnover leads to taxation of short-term capital gains. These are the highest taxes you can pay on a stock sale. Unfortunately, fund managers are often forced to sell shares in the pursuit of short-term results, leading to higher taxes. These taxes absorb the fund’s real income, which is another benefit for long-term investors.
Media pressure to invest like professionals
The more you unpack these studies of professional fund returns, the more you realize the benefits of keeping your winning stocks simple. And yet the financial media mislead investors into thinking that this is the game they need to play.
Take the catchphrase from Jim Cramer’s hugely popular show bad money for example: “There’s always a bull market somewhere, and I’ll try to find it for you.”
This suggests that individual investors should aim for returns anywhere in the market. Not only is this a tiring exercise, but it also eliminates the only advantage you have over institutions, which is time in the market.
Instead of trying to trade these market shifts, investors should use them as an opportunity to buy quality companies at bargain prices.
Wall Street usually misunderstands the big winners
The numerous mega-winners written off as doomed by Wall Street also testify to professional underperformance.
Amazon (AMZN 3.15%) is the most prolific of these examples. From headlines like “Amazon.bomb” to countless pundits predicting the company’s demise, Wall Street’s rejection of this big winner is well documented.
Still, Amazon’s total return compared to S&P500 speaks for itself:
AMZN total return level data as per YCharts
Most recently, Wall Street directed its criticism at the manufacturer of electric vehicles Tesla (TSLA 1.24%). Doubts about the company’s ability to maintain a broad lead in the industry, as well as negative sentiment towards various other disruptive technologies, dominated headlines and talk show discussions.
Meanwhile, stocks have significantly outperformed the market over the past decade:
SPY Total Return data from YCharts
This isn’t a comment on Tesla’s business, but rather further proof that Wall Street has a track record of missing big winners.
Excellence is all about patience
If you extrapolate why institutional investors are underperforming, you find that over-trading is terrible for long-term performance.
Rather than throw in the towel because the pros can’t beat the market, realize that you have a huge advantage when you don’t have clients and year-end bonuses influencing your portfolio decisions.
Whether it’s Wall Street’s near-term investment outlook or a general lack of optimism about new and disruptive companies, the financial media’s reports of missed winners should only increase your belief in your ability to…beat the market.