How you can invest better than many pros

How does "career risk" affect investment returns? A curious part of a report from a US investment house (1) has caught the eye. The author’s advice to professional investors when approaching how they were looking at the share market was that when they were determining their holdings they should take into account “what your career risk allows.”

To translate, in a pithy (and real-world) kind of way, professional investor readers were being told they should invest intelligently, but with a clear understanding that if they step away too far from the pack it may be a career-limiting move.

That’s where individual investors can have an advantage over many professional investors. The vast majority of professionals are judged according to their performance against an index; for example, the S&P/ASX200 for Australian sharemarket investors, the MSCI World Index for global sharemarkets.

These investors have their success measured by how much they can beat the index. If they move too far away from the index, then they may underperform versus their competitors, and perhaps do themselves out of a job. They think it is much better to be in the middle of the pack and reduce their career risk.

From a more systematic perspective, fund managers who invest relative to an index have trouble maximising their performance. Their investment rules mean that there is only so much more or less they can buy of a particular stock no matter how much they like or hate it.

Taking a current example, Microsoft makes up about 3.8% of the US S&P500 market index (2). An actively managed fund that is meant to be beating that index may decide that Microsoft is significantly undervalued; ie, the fund manager is extremely ‘bullish’ on the stock. However, her investment rules mean that she is limited in the amount that she can go ‘overweight’ a stock compared with the 3.8% benchmark weighting. She may only, for example, be able to move to a maximum 4.2% weighting in her portfolio.

There are strong motivations for this – it reduces the amount the fund can underperform the index if the fund manager is wrong – but it also limits the effectiveness of her investment research and conviction.

As an individual investor, you aren’t so constrained. You can back yourself to the limit of your knowledge and confidence, being wary that stocks go up as well as down and you may not get your capital back.

Individuals can build their portfolios based on their own requirements – when they will need dividends paid, over what time period money can be committed, and individual tax issues. No fund manager can account for those.

For our part, we don’t invest to a benchmark. We should make it clear that we do put benchmark data on our website because the industry likes us to do so. However, the makeup and weightings of a benchmark do not play any role in how we determine our portfolios. We don’t go into an investment meeting with our recommendations in the one hand and the benchmark information in the other, then attempt to marry the two.

If we aren’t convinced on a stock, we don’t own it – that’s it. No conviction = no investment.

This article reflects opinions as at the time of writing and may change. PM Capital may now or in the future deal in any security mentioned. It is not investment advice.

Footnotes:

1. Is the U.S. Stock Market Bubble Bursting? A New Model Suggests “Yes”, by Martin Tarlie of GMO, 1/18/19
2. iShares S&P 500 ETF, underlying holdings