Small investors have two big advantages over the pros:

1. They can wait until a position performs.
2. They can concentrate their holdings in a few stocks and buy just their top picks.

These advantages will let a small investor beat the markets by picking stocks where even the best pro cannot, at least once he has a lot of money under management. But these advantages only help you if you use them. Today we’ll talk about how you need to invest to use your advantages to the fullest. (This article skims the surface. If you want to get all the details and strategies, check out Investing to Win.)

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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.

Investing to Win

Pros Don’t Beat the Indexes because of Two Disadvantages

Pros don’t beat the indexes for two reasons: 1.They have too much money to invest and 2.They need to perform every quarter. Having too much money means that they need to buy not only their top pick, but their top five or ten. If they were to just put everything into their top picks, they would end up pushing up the share price in those stocks and then owning the companies because they have billions to invest. Even if you have a million to invest, you can generally just invest in your top picks.

Needing to perform means that they need to be right, right now. If they make 5% while the indexes make 15% in a quarter, investors in their funds will sell and move over to someone else who made 20% for the quarter. Because Assets Under Management (AUM) is used to determine how much money the fund collects, fund managers are keenly concerned about cash flowing out of the fund. While they may know that a stock will do well over the long term, if it is having a rough year or even a rough quarter, they may need to sell out and buy something else. This means that they are buying high and selling low (the opposite of what you want to do).

SmallIvy Book of Investing: Book1: Investing to Grow Wealthy

Many Individual Investors Don’t Use Their Advantages

Unfortunately, a lot of investors don’t use their advantages in the way that they invest. They buy just a few shares of a lot of companies. When they have winners, they make a few hundred dollars (or maybe a couple of thousand) instead of the tens of thousands of dollars they would have made if they had stuck to their top picks. They try to time the markets, buying a stock because it dips or because it is climbing, then sell out too soon when the stock is up or too late when it is down.

Because of this, while the pros will typically underperform the indexes by a few percentage points, individual investors will make very little at all over long periods of time. Many would have been better off just putting their money into bank CDs because they would get a higher return than they do from investing the money poorly. Really, if you are going to invest this way, you would be best served just putting your money into a set of index funds and then ignoring them for 30 years. And, really, this is exactly what most people should be doing with the bulk of their retirement savings. Index funds of different types (large, small, US, non-US) with regular investments from your paycheck will serve you well and you’ll do better than most people. Just ignore the markets and keep adding as you go.

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.)

Adding Individual Stocks Well

If you have the nack for stock picking, you can add a few individual stocks in a regular brokerage account (or use part of an IRA) and possibly beat the markets. Here, you need to use your advantages to have any hope of doing so. Here’s how:

1. Gather a list of a few great companies. Start by screening companies and find those in a few different industries that have potential to grow over the next several years/decades. You’re looking for companies that are well managed and have great products. You’re also looking for companies that have room to grow, so those like Walmart and Clorox shouldn’t make your list. Even Google and Amazon are getting too big to grow more.
2. Build up positions. Start to buy into these companies and build up sizable positions. You’re looking to eventually have 500 to 1000 shares of each company. This means that if they do well, you should see substantial gains.
3. Be patient. Realize that you may have picked a great company, but it may take a while for the markets to see this. This might be a decade or more. As long as the company keeps growing and making higher earnings, eventually share price will follow. In the worst case they’ll start paying out a bunch of cash in dividends, so you will eventually be rewarded for your patience.
4. Cut bad or huge positions. Do you ever sell? Yes. If a company doesn’t perform as a company, meaning they don’t see the earnings growth after a few years that you expected and it is obvious they won’t, cut your losses and move your money elsewhere. If they do really well, such that they become a huge percentage of your net worth, go ahead and sell some shares and spread your money into index funds and other positions. For example, if a company becomes more than 5% of your net worth, sell 20% and put the money into other things.

Once you have a net worth of more than a million dollars, you will have a core set of index funds, plus maybe 10 to 15 individual stock positions. Some of these may be worth up to about $50,000. Others will be in the $5000 to $25,000 range. If you’ve picked well, you’ll have at least one position that just keeps growing, allowing you to harvest $10,000 to $50,000 every few years.

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..