Many investors complain that stock investing is a rigged game. Institutional money managers use elaborate software and powerful computers to constantly monitor a multitude of market indicators and generate buy and sell orders. They control the capital markets, their trading activities determine asset prices, and they can trade on information before it becomes known by ordinary folk. While these complaints may be true, none of the so-called advantages possessed by institutional investors can compare to the three advantages that you have over them.
Your first advantage is that you have a long-term time horizon. Managers of hedge funds, mutual funds, pension plans and endowments are graded against their peers on an annual basis. Few institutional money managers can survive one year of poor performance relative to their peers and consecutive years of underperformance is a shortcut to the unemployment line. Most adopt security selection and/or market timing strategies in an attempt to maximize short-term performance, even though these strategies rarely lead to long-term investment success.
They find themselves trying to make sense out of, or discern patterns in, random events in the capital markets. Most have ceased being stewards of their investors’ assets and become short-term speculators who gamble with other people’s money.
Success is defined as outperforming the majority of their competitors or beating their benchmark index. It has nothing to do with the long-term welfare of their shareholders. On the other hand, you don’t need to focus on short-term performance. You can exercise patience, adopt a long-term view and use annual rebalancing instead of frantic trading to achieve your financial goals.
Rate of return
The second advantage that you have over institutional investors is that your portfolio can be designed to achieve a target rate of return instead of the highest possible return. Your financial plan should contain a target rate of return that will allow you to achieve your financial goals. This target rate of return will be inversely proportional to the amount of money that you plan to invest during your accumulation years. Risk-averse investors can lower their target rate of return by increasing the contributions to their retirement accounts. This will allow them to own a more conservative portfolio which will temper volatility when the stock-market spumoni hits the fan.
Investors who adopt a long-term view and practice deferred gratification (investing instead of spending), are likely to find that their target rate of return is less than what their portfolio allocation has yielded in the past.
I recently created a financial plan with a target rate of return of 6.0%. I’m assuming 2.5% inflation, so the real (inflation-adjusted) target rate of return for the 60% stock/40% bond portfolio is 3.5%. For the past 45 years, this portfolio allocation has yielded an average annualized real return of 5.1%. For the past 90 years, it has yielded an average annualized real return of 5.7%. The difference between the historical performance of the portfolio and the target rate of return provides a buffer should future stock and bond returns be lower than in the past.
Few investors know their target rate of return or how to calculate it. Most mimic institutional investors and seek the highest possible return from their portfolio. In pursuing market-beating returns, few investors realize that their quest will likely bring higher taxes, higher expenses and additional risk. For most investors, a better investment outcome and greater wealth will be achieved by owning a balanced portfolio with a higher allocation to stable assets that tend to moderate portfolio volatility.
If you focus on achieving a target rate of return instead of a maximum return, you’ll be less likely to engage in the counterproductive activity of portfolio tinkering. Your focus will be on your portfolio’s return instead of the performance of its individual components. It will be easier to ignore the noise generated by the performance chasing, trading frenzy of institutional investors.
You’re on your own
In the intensely competitive business of money management, institutional investors will do whatever is necessary to avoid losing AUM (assets under management). This requires them to constantly monitor what their competitors are doing and explains why so many of their portfolios hold similar assets. They must fixate on, and have an opinion about, every shimmy and shake in stock prices. They do this to keep from being “out-babbled” by the competition and to give their investors the impression that they are “on top of things”.
Your third, and perhaps greatest, advantage is that you don’t have to concern yourself with the activities of other investors or the market’s daily gyrations. Institutional investors can only envy your option to sit and do nothing during times of market volatility. You have the luxury of focusing on the more important and enjoyable things in your life and enjoy the peace of mind that comes from knowing that, when it comes to investing, inactivity is often the wisest behavior.