In 1994, Warren Buffett acknowledged the weaknesses of mutual funds by offering this advice: “By periodically investing in an index fund, for example, the know-nothinginvestorcan actually outperform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.”
More than 20 years later, it’s still great advice for investors who have little interest in picking stocks but want to see their retirement savings grow. For decades, index funds have been hard to beat.
On the other hand, it doesn’t take a genius to be a know-something investor. These people…
- recognize pioneering companies when they disrupt or create a new industry.
- know when a company’s innovations align with society’s future needs.
- are comfortable taking short-term risks in exchange for long-term gains.
Personal investors can beat the S&P 500 (and the clear majority of mutual funds), thanks to 5 inherent advantages that the big players on wall street will never have.
Advantage #1: Ability to focus on a few great companies
Mutual funds vary in size from hundreds of millions to over one hundred billion dollars. With all that cash to invest, mutual funds are simply unable to focus their assets on a handful of great companies.
Mutual funds typically own shares of over 100 companies, and the largest holdings generally represent no more than 5% of total assets. This level of diversification means that meaningful gains must come from many holdings, which is likely the result of a strong overall market, not the fund manager’s skill. At about 5% of total assets, even if a fund’s largest holding crushes the market, those gains are often canceled out by many of the stocks that underperform.
By contrast, personal investors are free to focus their portfolios on whatever companies they wish, taking as much or as little risk they desire. Warren Buffett offered this advice for the know-something investor:
“If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding the money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential.”
Advantage #2: Ability to invest in small-cap or micro-cap companies
Let’s suppose you find an impressive, yet tiny, company in its early days. As an individual investor, you are free to invest as much as you wish into this company, once again taking as much or as little risk as you like.
Mutual funds, on the other hand, may have total assets that are 100 times larger than the value of that company. This makes it impossible for mutual funds to purchase a meaningful stake in small companies because doing so could result in the fund owning the company outright.
For example, if a 100-billion-dollar mutual fund tries to invest just 1% of its assets in that company, that would require a $1 billion investment, which may even exceed the company’s current market cap, rendering the deal impossible.
Therefore, mutual funds are forced to wait until those tiny, promising companies grow into large, established powerhouses, missing out on the largest growth.
Advantage #3: Fewer regulations and no fear of being fired
Personal investors are free to invest without worrying about thousands of people watching their every move.
Mutual fund managers are under close supervision by federal regulators, their bosses, and their investors, all of whom may have different goals and expectations.
The result is that mutual funds tend to be more conservative than individual investors, because as the famous saying goes, “Nobody ever got fired for buying IBM.” In other words, mutual fund managers will never be criticized for owning the big name, less-risky, steady players in the market, even though risk is where the outperformance lies.
Advantage #4: A long-term view
Personal investors understand that a long-term perspective eliminates the worries of short-term volatility, and performance over a 1-2-year time frame is less important than picking companies with great prospects over the next 5+ years. Personal investors accept the inevitable drops that great companies make on their way to long-term success.
Although mutual fund managers try to outperformthe market, they’re also under a great deal of pressure not to underperformthe market in the short-term. The result of these conflicting expectations is a conservative portfolio that stays just close enough to the market but struggles to outperform.
Advantage #5: Lower fees
According to the Investment Company Institute, the overall average expense ratio for mutual funds was 0.63% in 2016. This means that, on average, mutual funds had to beat the market by more than half a percent just so their investors could match the market. That’s no easy task, especially considering the other factors working against mutual funds I’ve already mentioned. Making matters worse, investors typically pay a commission on every additional investment into that fund. The fees add up, and it’s like starting a race yards behind everyone else.
On the other hand, individual investors get to start that race in front of the pack. By only having to pay a few dollars per trade, personal investors are free from the burden of having a percentage of their holdings eliminated year after year.
By default, personal investors enjoy efficient growth of their portfolio unhindered by massive fees, the ability to take a long-term view, invest without worrying about short-term volatility, experience the freedom of investing in companies of any size, and can focus on a handful of promising companies... All delightful advantages that encourage the know-something investorto take on wall street.
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