In any competition, one needs to know his or her own advantage in the game. In the game of investing, every investor needs to know his or her advantage. The small and individual investor has some advantages that the guys running billion dollar hedge funds wished they had. A smart investor takes these advantages and uses them when playing the ultimate game: investing. I hope you do too.
Fast and nimble.
Does anyone remember Long-Term Capital Management (LTCM)? The highly leveraged fund that burst in spectacular fashion in 1998? They got creamed in by the Russian bond debacle. So you may ask “If they realized that they were in a terrible position, why didn’t they get out?” The truth is, they very much wanted to get out, but they couldn’t. Their position was too large, and if they tried selling even a fraction of their position, they would have moved the market against themselves.
In times of a market panic, the thing that everyone wants but is lacking the most is market liquidity. Everyone wants to sell, but hardly anyone wants to sell! This is where the small individual investor has an advantage. While the big guys watch in agony looking at the ever increasing red numbers on the screen, the small guy can easily close his position (even in times of little market liquidity).
Speed is king. And because the small investor does not have a ton of money to play with, he or she essentially has speed on his or her side. The fast and nimble investors are able to quickly change positions in the market once they realize they’re wrong. Even if the big investors know that they’re opinion of the market is wrong, they still won’t be able to change their position (because it’s too big).
Not killing themselves.
Big investors tend to buy into the market when the market is falling. Why? Because they are afraid of bidding the price up against themselves. For example, Warren Buffett starting buying silver in 1997, when he saw that silver prices were a really good buy. He ended up buying all that he wanted (which was 33% of all available silver). But the consequence of his buying was that he, alone, bumped up the price of silver by 37%. In other words, he just passed up 37% worth of investment returns. The small guy could have bought all in into the silver market, and he would not have bidded the price up against him or herself. Size is the enemy of performance.
Can be hugely profitable.
Big hedge funds with billions of dollars under management are forced to pass up many opportunities. Small investment opportunities can be hugely profitable, but because the market is so small, they are forced to pass it up. For example, XYZ Fund has $20 billion under management. They may see 50 different investment opportunities for investments of $2 million that will each yeild a 80% gain. But it’s hardly worth their time investing in these, because what about the other $19.9 billion in their fund? They won’t have enough time to invest the other $19.9 billion. Whereas a small investor who only has $2 million can go headlong into investing into an investment with a potential yeild of 80%.
As an investor has more and more money to invest, it becomes harder and harder to produce the same spectacular results, because there simply aren’t enough brilliant investment opportunities. This leads to my next point.
Something that I stress to all novice investors is that they should find a market they’re comfortable with, and stick to it. I mentioned in my post titled Common Investment Mistakes that diversification is the enemy of performance. Only by becoming extremely familiar with an individual market can the investor produce above average returns. Unlike the small investor, the big funds and money managers don’t have the luxury of being able to focus on one market. Because they need to invest a lot of money and the market’s capitalization is often too small, they need to diversify their holdings, thus diversifying their focus, and thus accepting small investment returns.