Individual investors now have unprecedented access to investment information and markets. Detailed security statistics and real-time news are easy to obtain online, which has leveled the informational playing field between Wall Street and Main Street. But even though individual investors are constantly encouraged to "do it themselves," can they can manage their own investments as well as the professionals and without the assistance of paid advisors? More importantly, should individual investors go it alone? These are challenging questions that require honest self-evaluation to answer. Let's take a look at how you as an investor can tackle this subject and form an opinion on the matter.
Individual Investor Performance
Studies have shown the track record for individual investors is not encouraging. DALBAR, a leading financial services marketing research firm, released a study that showed from 1990 to 2010, the unmanaged S&P 500 Index earned an average of 7.81% annually. Over that same period, the average equity investor earned a paltry 3.49% annually.
The difference in wealth accumulation between these two numbers is staggering. Over 20 years, a $100,000 investment would grow to nearly $450,000 if compounded at 7.81%, while a $100,000 investment would grow to only $198,600 if compounded at 3.49%! It's important to note, however, the performance differential had little to do with the returns of the average equity mutual fund, which performed just shy of the index itself, but was most affected by the fact that investors were unable to manage their own emotions and moved into funds near market tops while bailing out at market lows. (For related reading, see: How to Avoid Emotional Investing.)
Spock vs. Captain Kirk
One of the constant themes of the original 1960s television series "Star Trek" dealt with the relative strengths and weaknesses of emotion versus reason. Captain Kirk, the captain of the Starship Enterprise, often made decisions based on his human instincts, which his purely logical Vulcan first officer, Spock, sometimes found irrational. However, these "gut-based" decisions yielded positive outcomes that seemed improbable based on reasoned analysis. At times, emotion and instinct proved successful, even in the face of reason. Unfortunately, while instinct prevailed in outer space, when it comes to investing, Spock would beat Captain Kirk over the long-term. There are instances when following a hunch proves profitable, but not very often. Over the long-term, reason, logic and discipline will beat out emotion every time.
Our problem is that, like Captain Kirk, we are human. Divorcing ourselves from emotion is against our nature. Still, to the extent we are able, that is what we must do. Fear will lead you to sell just when an investment's falling price is near its bottom. Over-optimism will cause you to buy just when the price is at its peak. Disciplining your emotional side is no easy task, even for a trained, experienced professional. Before you attempt to do it yourself, you must make an honest assessment of your emotional make-up. You don't have to be Spock, but you can't be Chicken Little either! (For related reading, see: The Financial Markets: When Fear and Greed Take Over.)
If you determine that you have an essentially rational predisposition, you can largely control the remaining emotional vestiges by leaning on a process. You must develop some rational, logical process to maintain discipline in the face of emotion. Without this process, you are destined to underperform. This process must be quantitative in nature and steadfast in approach.
Basic Attributes of a Successful Investor
Assuming you possess the proper emotional constitution, what other basic abilities and resources are required to successfully make your own investment decisions? Some proficiency in math is essential. You do not need to be a financial analyst, but you do need to be comfortable with numbers. Words in an annual report or a prospectus can paint a deceptively positive picture, but numbers are harder to manipulate. You also need to be able to execute present value and/or future value calculations. You will find this easy to accomplish using any financial calculator.
You also need a way to accurately and reliably track the true performance of your overall investment portfolio. Investors often suffer from selective memory. Successful selections are remembered clearly while unsuccessful selections are conveniently forgotten. Self-deception is no ally. You must be able to honestly assess how your do-it-yourself efforts match up against the professionals. Fortunately, brokerage houses are making reliable portfolio performance tracking more accessible to the individual investor.
In the final analysis, however, your requirements will be based on how much of the process you decide to do yourself. This does not have to be an all-or-none decision. You may find it wise to outsource some parts of the process to others. (For related reading, see: How to Manage the Risk of Your Own Portfolio.)
Know Your Limitations
You must make an honest assessment of your limitations to be successful in trading. Start with an area in which you have a high level of confidence and let others do the rest. You may feel confident you can act as your own advisor but need to use professional money managers for mutual funds or private money managers for your investment assets. You may feel confident you can structure and manage a diversified portfolio of individual stocks, but are not confident you can do the same with bonds, which can be significantly more complex. Here again, you can make your own stock selections but use outside managers to handle your fixed-income investments. As time passes and your abilities grow, you will be in a position to bring some or all of your outsourced areas back in-house.
Winning the Loser's Game
Winning the Loser's Game (2002) by Charles D. Ellis sprang from an article he wrote in 1975. It was the article John Bogle cited as one of the major influences in his decision to create index mutual funds when he started Vanguard Group. In these pieces, Ellis states most professional money managers fail to consistently outperform the market because they are the market. Regardless of asset class, market landscapes today are dominated by highly skilled, highly trained, highly intelligent investment professionals. To think you can consistently do a better job than this amalgamated brain-trust borders on megalomania.
What you may be able to do, however, is compete with these professionals by using their collective wisdom. For example, several decades ago, when McDonald's was the top hamburger chain and Burger King was number two, a marketing study revealed Burger King had developed a highly cost-effective way of deciding where to locate new restaurants. While McDonald's would spend millions of dollars carefully determining ideal spots to build, once that decision was made and construction began, Burger King would simply build a new restaurant across the street. By smartly leveraging McDonald's research, Burger King achieved a virtually identical location outcome at a fraction of the cost.
A great deal of time, energy, brain power and resources are expended on Wall Street to generate volumes of information and data. With the internet, most of the key components of this research are readily accessible for free. Use them! (For related reading, see: Information Overload; How It Hurts Investors.)
You Can Do It
Professionals struggle every day to effectively compete. Why, then, should it be easy for you? Your emotions will attempt to sabotage your effort, and the endeavor will require time and dedication. You may not need to give up your day job, but investing may need to become your primary hobby. Despite these challenges, you do have some advantages. (For related reading, see: Why Warren Buffett Envies You.)
Your largest advantage is no one knows you better than you know yourself. This places you in a unique position to tailor your investment strategy more precisely. You also do not face many of the short-term pressures the professionals face. Despite their supposed long-term focus, they are largely judged on recent performance, and failure to perform well in the short-term can lead to job loss. You are in a position to take a longer-term perspective. There is also a herd mentality on Wall Street. Going against the prevailing stampede is very difficult, even when that stampede is going in the wrong direction, as with the tech bubble in the late 1990s or with the subprime mortgage meltdown of 2007. You are not a member of the herd, so you are in a better position to go against the flow.
The Bottom Line
Becoming your own investment advisor and money manager is not easy, but it can be done, and if you truly enjoy investing, it can be extremely rewarding. (For related reading, see: Tailoring Your Investment Plan.)