One would think that if professional money managers can’t routinely beat the markets, the small investor wouldn’t have a chance. But the truth is that the small investor actually has advantages that can allow him to beat the indexes when the professional money manager can’t. In this article we’ll reveal what these advantages are and discuss how you can use them to do what the pros cannot.

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Want to learn the secrets to investing and really turbocharge your returns? Check out the second book in The Small Investor series, Investing to Win. This book presents 40 years of investing experience. Someone starting with zero knowledge of investing and the stock market could take this book and learn all that they needed to invest and do well. It would also be useful to someone who has invested and traded stocks for a while but who is really not getting the kind of returns desired.

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Pros Don’t Beat the Indexes

One would think that stock market professionals, such as mutual fund managers, would have a huge advantage over the average investor. They have millions of dollars to hire people to do research, get all sorts of software and materials, and attend shareholder meetings in person. Janus Funds had commercials where they talked about their managers visiting companies and learning all of the details. (And don’t think that these folks are traveling coach and staying at the Motel 6. They’re going at least business class and staying at the Marriott or the Hyatt. They’re having fine meals out, because “travel is so grueling.”)

But the results have shown that even with all of those resources and money spent, with all that training and degrees, and with that being their full-time job, pros don’t usually beat the index funds. You know, those funds that just buy whatever is on a list of stocks that represents an area of the markets. A list of stocks to which everyone has access. If the managers ever do beat the indexes, it lasts for a few years and then they eventually fail. In fact, most managed funds actually return less than the index funds.

It isn’t that they don’t have the skills. It isn’t that they don’t have the resources. It isn’t that they don’t have the time. It’s that they have inherent disadvantages to the index funds. Specifically, they have a lot of money to invest and they have costs – salaries, subscriptions, computers, travel, those steak dinners. Index funds have none of these costs – they don’t need to travel, subscribe to anything, or have a big staff. They just need to know what’s in the index and adjust periodically to match it.

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But don’t pros have the ability to pick the best stocks, so shouldn’t they be able to beat the indexes and make up for their costs? Let’s say that you actually have a guy who can choose the best stocks in an industry. Having a lot of money to invest means that he can’t just buy his top picks. He still needs to buy his second, third, and maybe fourth choice. If he tried to put the billions of dollars he has to invest in his top choice, he’d own the company and would overpay to do so. There just aren’t enough shares out there to absorb all that money. He therefore ends up buying so many stocks that he just gets index performance anyway.

Another factor is time horizon. The pros need to perform every quarter. If they don’t, they could see money flow out of their funds and they could lose their jobs. This means that they can’t wait for a stock to turn around. They need to be right both about the stocks they pick and the timing of when they buy them. No one can do this consistently. And all the buying and selling just increases their costs and your taxes.

If you’d like to learn more about how to decide how much you should put in different types of assets, Sample Mutual Fund Portfolios gives lots of information and examples of how to make allocations for all sorts of different goals, including retirement.)

Small Investors have the advantage

By being “small” and not having billions of dollars to invest, small, individual investors don’t have the restrictions that a money manager does. Unless it is a penny stock, an investor could put $1M or more into their top stock and not affect the price in any appreciable way. She can also buy a stock and just wait for it to perform. There is no quarterly report to put out. Time is on the side of the small investor.

Should you put it all in one stock? Probably not (unless it is your first stock buy and you’re going to continue to add more positions). Bad things can happen to any company and you don’t want to end up losing everything on a bad choice. You also might find out that you just aren’t good at picking stocks (check out Investing to Win for stock picking methods for individual investors) and would have been better off in a few index funds.

But in addition to a solid set of index funds to cover retirement and make sure you see your wealth grow over your lifetime, it can definitely be worth it to add a few stock positions to your portfolio. If you put in a little time to learn how to pick stocks, individual stocks can make a big difference in your life. To make this possible, you need to do the things that a money manager can’t:

1. Buy in sufficient quantities to make a difference (like 500 to 1000 share positions). This means that when you do have a stock that goes up a lot, you’ll make a significant gain. Hold 10 shares of a stock that goes up $100 per share and you’ll make $1000. But hold 500 shares and you’ll make $50,000. Life changing money.
2. Plan to hold for a decade or more rather than trying to time the markets. No one can guess where the markets are going consistently, but if you choose stocks that have good potential to grow and expand long-term, you can just buy and wait for things to happen. Time reduces your risk.

Maybe one of your positions will become a ten-bagger and become the down-payment on a home or a new car. You may have one that helps cover your kids’ or grandkids’ college costs. Then again, it may not work out (which is where the index fund back-up comes in).

Don’t know how to invest? Check out The Smallivy Book of Investing for a great primer. It gives you all the information you need to start investing and managing your wealth.

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmalllIvy

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing..