How to beat the professionals at their own game

I understand if you’re sceptical. How can the average private investor even begin to compete against an experienced professional fund manager with access to the best research by the brightest minds in the business? Heck, despite their overly-generous salaries, even the majority of these institutional investors under-perform the market over the long term. What chance do we have?

I’m sensitive to this argument. Those with little interest in researching companies should definitely consider employing the services of a professional (or better still, use low-cost index funds or ETFs). Nevertheless, I’m also of the opinion that those who are willing to assume responsibility for meeting their financial goals can take advantage of things that many managers can’t. Let me explain.

All killer, no filler

It may sound obvious but those who select their own stocks have total control over their portfolios. They’re not constrained by the aims of a particular fund and can make buy/sell decisions quickly without the need for approval. Private investors can buy what they want, when they want.

Fund managers must stick to the plan. If their fund takes a value approach to investing, they can’t do anything if momentum stocks are flourishing. If their fund only permits buying UK companies, they must ignore excellent opportunities elsewhere. And if they must jettison a large holding, this can take a while. 

In addition to the above, the fact that private investors call the shots also means they’re free to focus on their best ideas. Since investing is never completely devoid of risk, fund managers must mitigate this to the best of their ability by populating their portfolios with a sufficient number of companies, even if the investment case for some of these is less than convincing. While private investors should never disregard the importance of being diversified (especially during times of market panic), a thoroughly-researched portfolio of 15 or so stocks from different sectors is often better than one containing 50-100.

‘Buy on bad news, sell on good’

Another massive advantage that comes from making your own investment decisions is being able to take advantage of time arbitrage. This is when a particular share with a poor short-term outlook is sold en masse by institutional investors, even if little has changed with regard to the company’s long-term prospects. Perhaps the business has failed to reach overly ambitious sales targets (ASOS back in 2014) or external factors are weighing on the share price (Royal Dutch Shell in January). Most fund managers don’t have the luxury of being patient. They must answer to others (employers and clients) on a regular basis and are therefore forever comparing themselves to benchmarks that only a minority actually beat. If they lag the market return for too long, they risk damaging their careers. So they sell.

Cunning private investors with time on their hands can buy otherwise high-quality businesses and reap the rewards that come from being able to act independently. If you think Sports Direct, Restaurant Group and easyJet can all recover from an awful few months, purchasing their shares today might be an inspired move.  The only caveat is that you must be able to distinguish between unexpected, short term snags and those things that indicate a failing company. Get these confused and you could be catching a ‘falling knife’. 

Go small

One final advantage for private investors is their ability to buy companies further down the food chain. Thanks to their need to focus on big companies, small-cap or micro-cap stocks with bright futures are often ignored by most fund managers.  Even those that are interested are often unable to buy these stocks in sufficient bulk.  Since private investors can devote a lot more time to learning about a company and benefit from mis-pricing, the former's misfortune could be your opportunity.

Given this, if you're willing to embrace your investing edge and take on board more risk for the possibility of higher returns, you'll need to check out this special FREE report from the Motley Fool. We've identified a top small-cap share we believe has the potential to be a big winner over time.  Better still, it's yet to appear on most investors' radars.

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Paul Summers owns shares in easyJet. The Motley Fool UK owns shares of and has recommended ASOS. The Motley Fool UK has recommended Royal Dutch Shell B and Sports Direct International. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.