For the individual investor, Wall Street is often a lose-lose proposition. The system is set up for the small investor to fail and for the big players to gain. Before getting into the meat of the discussion, let’s step back and look at the typical stock market investing strategy. It’s all about timing, right? It’s all about anticipating the market’s or a particular stock’s next move.
The problem with the timing strategy is that the house almost always wins. Some people will get lucky some of the time, but nobody gets lucky all the time. The data backs this up.
In 2020, S&P Dow Jones Indices, the “de facto scorekeeper of the active versus passive investing debate,” recently released its “SPIVA U.S. Year-End 2020” report.
Here are the highlights of the report: Over the most recent 20-year investment horizon, active managers of 96% of large-cap growth and large-cap growth funds, 94% of large-cap funds, 90% of all multi-cap funds, 88% of mid-cap and small-cap funds, and 86% of all domestic funds failed to outperform their benchmarks. In other words, over a 20-year period, over 90% of professional fund managers failed to beat the markets.
Even the professionals admit they’re often wrong:
‘Even at Bridgewater, we have 400 people spending day in and day out mapping cause-and-effect linkages in the world, and we still get 40% of our calls wrong.’ – Nir Bar Dea, Chief Executive Officer at Bridgewater Associates
That was the head of one of the biggest hedge funds in the world discussing at the Qatar Economic Forum how difficult it is, even for his company, to get market calls and investments right.
Hedge funds can afford to play with other people’s money and lose. The individual investor only has their own money to lose. And these individual investors make common mistakes that make it difficult to beat the markets. What they don’t know is that large investors with immense resources may not be able to time the markets, but some are able to predict collective investor behavior to profit from their mistakes. Charlie Munger, Warren Buffett’s late investment partner and friend, boasted this to his friend in 2015.
“Warren, if people weren’t so often wrong, we wouldn’t be so rich,” he told Buffett during the annual shareholder meeting in 2015. These sentiments have been echoed by other successful entrepreneurs, such as Mark Cuban, who once said his business philosophy was to “look for inefficient markets.”
Exploiting the mistakes of individual investors and going against the grain is how some of these deep-pocketed investors profit.
So what are some common investor mistakes?
Succumbing to Emotions.
Emotional decision-making can severely impact investment performance. Cognitive biases such as herd mentality, loss aversion, and hindsight bias often lead to poor choices. Warren Buffett advocates being a “no-emotion person” in investing to avoid such pitfalls.
Misunderstanding Diversification.
Investors misunderstand diversification and often over-diversify, therefore ending up diversifying away their gains.
Trying to Time the Market.
Timing the market is a common, but futile, strategy. Generally, a long-term strategy is more effective than trying to predict short-term market fluctuations.
Overconfidence.
Overestimating one’s ability to predict market movements often leads to disappointment. For instance, many investors were overly optimistic about interest rate cuts by the Federal Reserve, which did not materialize as expected.
Misusing Leverage.
Leverage can amplify gains but also magnify losses. Borrowed capital can lead to substantial losses during market downturns.
Wall Street’s inherent biases present formidable challenges for individual investors. The odds are stacked against them in a playground where even professionals with extensive resources often falter, making it critical for individuals to avoid common mistakes and adopt prudent investment strategies.
So, there are two types of Wall Street investors who make money:
professionally managed hedge and mutual funds that make money from fees they charge to their investors; and
those like Warren Buffett who exploit the mistakes of individual investors.
Why play a game stacked against you and be exploited by those who stand to gain from you?
Don’t let the system exploit you… Don’t play the game.
Sophisticated investors avoid the common mistakes of individual investors by avoiding the public market sandbox. Instead, they prefer private markets insulated from crowd behavior, which saves them from themselves.
Investments in private equity and commercial real estate are for savvy investors with a long-term view. With long lockup periods, these illiquid assets prevent investors from acting on their emotions by taking herd behavior out of the equation entirely.
Don’t play where the exploiters lurk, and you won’t be exploited.