QUALIPORT
How Amateur Investors Can Beat The Pros

By Maynard Paton (TMFMayn)
September 29, 2003

Professional fund managers have a poor reputation. Earlier this year, the WM Company published a study that found:

* During 2002, two out of five active funds failed to beat the FTSE All-Share Index;
* Of the 48 active funds with twenty-year records, only ten out-performed the benchmark FTSE All-Share Index, and;
* Over a 14-year period to the end of 2002, the average tracker return was greater than 52% of active funds.

Why do the pros have such a bad record? Here are five of the main reasons, all of which can be avoided by the amateur stock-picker.

1) Quarterly pressure

Sad to say, but most buyers of managed funds put far too much emphasis on recent past performance. One or two years of underperformance and they start to question the fund manager's ability. Three or four years of underperformance and the fund manager's looking for another job.

Private investors have a great advantage over their professional rivals: they can't be sacked. Without the client/career pressure hanging over them, a long-term focus can be adopted. Part-time investors have no need to switch constantly into the latest hot stocks, in the hope their fund remains in the top quartile. Remember, investment connoisseurs like Charlie Munger and John Maynard Keynes have seen the market beat their portfolios over four straight years in the past.

2) Small cowardly bets

Industry regulations hamper the chances of professional managers doing well. For instance, unit trusts can't hold more than 10% of their capital in one particular share. That's unfortunate, since big bold bets are what's required to diverge significantly from the index average.

Another thing that hinders performance are 'house lists'. Quite often, investment organisations restrict their managers to a limited universe of possible shares. The ordinary investor has no boundaries on diversification or deciding which companies can be bought or sold.

3) Information overload

A key feature of successful investing is 'keep it simple, stupid'. Such advice is tailor-made for small investors, most of whom can spend only a few hours a week tending to their portfolios. On the other hand, full-time professionals fill their days by speaking to company managers, reading in-depth analyst research and studying accounts. However, the pros run the risk of not seeing the wood for the trees.

To a private investor, Unilever (LSE: ULVR) is simply a steady, global company with plenty of proven, market-leading brands. To the professional though, possible worries over shampoo sales in Mexico, Italian washing powder margins, the impact of currency fluctuations on Asian profits and a recent decline in the company's EV/EBITDA ratio could distort the investment picture. But do any of the nitty-gritty concerns offset the company's all-round product strength?

4) Think small

Liquidity issues often hinder fund managers when considering small caps. As such, most funds have to concentrate on large or medium-sized companies. And because of the greater general interest in bigger companies, spotting market anomalies can become quite difficult.

A lack of institutional coverage usually creates more investment opportunities at the tinpot end of the stock market. Although smaller companies do tend to have greater operational risks, there are those around that do dominate inherently niche industries.

5) Charges

A typical managed fund will levy a 5% initial fee and an ongoing annual management charge of 1.5%. In an era of low investment returns, such cost structures can substantially dent future gains.

The only charges suffered by the DIY stock picker are dealing costs, which are minimal if a long-term investing horizon is used. If a low-cost ISA is used to protect capital gains from the taxman, investors can generally expect annual fees to range from £20 to just 0.5% of the portfolio. The Fool's ISA Centre has more details.

Summary

An amateur stock picker can beat the average professional by:

* Thinking long-term;
* Taking big bold bets;
* Reducing the information overload;
* Considering small companies, and;
* Keeping costs low.

Of course, none of this actually guarantees the private investor can still go out and actually beat the market average. Although the full-time professional is handicapped in many areas, identifying winning shares still remains as difficult as ever for the part-time amateur. As such, the best way to beat the pros is via the simple index tracker, which, as WM Company's study showed, beats most managed funds hands down.

More: Motley Fool's ISA and Index Tracker Centre.

A version of this article was first published in September 2002.