5 Things That Give You an Investing Edge Over Wall Street's Big Guns

Ace up your sleeve
Forbes columnist Phil DeMuth recently posed the question: "What is your edge as an investor?"

After admitting that having an edge is not "as easy as it sounds," DeMuth walks through some possible edges. These range from the highly unlikely/illegal (such as working at the FDA and investing in a drug stock before its approval) to the tougher to quantify -- like being "good at spotting trends" or being "a market-beating stockpicker."

So if you're not Warren Buffett or willing to risk jail time for insider information, is there any hope for you to beat the market? Do individual investors have any advantages over the world of Wall Street Goliaths?


The Forbes article points out several strategies that everyday investors can implement to at least equal the market's return (through investing in index funds) and maybe even do a bit better (by buying index-like investments that seek out market anomalies).

But aside from strategies, there are some inherent qualities of being an individual investor that give you an edge. These are advantages that could make you more successful than even the best mutual fund managers -- not to mention famous investors like Warren Buffett.

In fact, Buffett once quipped that if he had only $1 million in net worth (instead of his current $53.5 billion), he could guarantee 50% annual returns.

So why is he so confident in making such a bold promise? He never specifically answers that question, but I've put together a list of five "edges" small investors have that I think even Buffett would agree with:

1. You've got no pesky shareholders. Much of a money manager's time is spent thinking (and worrying) about their customers (aka, shareholders). A large investor might call up and ask why his money's not growing as quickly as he'd like -- and then after that, another could send an email explaining their moral objections to the money manager's most recent purchase.

It never ends.

But when you're investing for yourself, you only have yourself to answer to. No one will harrass you about inevitable downturns or berate you for a weak quarter.

2. Your interests are perfectly aligned. Believe it or not, not all mutual fund managers own shares of their fund. In fact, a 2007 study from the Georgia Institute of Technology discovered that only about half of the managers of the 1,406 funds they studied did.

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So if they're not profiting directly off their investing decisions (and knowing that self-interest is a powerful tool), how are you to believe they're putting 110 percent of their focus in doing the same for you?

You can't.

But when you're working on growing your own portfolio, you know your best interest and full focus is tied directly to your own money -- and there's no doubt you'll be giving 110 percent of your focus to how best to grow it.

3. You've got flexibility. Mutual funds typically have a stated purpose -- and their investing decisions must wind up within those boundaries. Large-cap funds must invest mostly in large caps, emerging market funds in foreign stocks, and so on.

But when you're investing on your own behalf, you can own a broad assortment of large caps, small caps, real estate investment trusts, value stocks, growth stocks -- your universe to pick from is limitless.

4. You can control costs. The majority of mutual funds have to trade stocks daily to maintain cash flows. After all, new money is constantly flowing in. And some investors also need to withdraw their money for a variety of reasons. This means cash is regularly coming in and cash must regularly go out. Unless the manager keeps a hefty chunk of his portfolio in cash reserves to account for this, he'll likely need to make regular purchases and sales.

Of course, all of this trading comes with costs. Every transaction has a commission associated with it. On top of that, all the regulatory paperwork behind each trade requires staff members to maintain these day-to-day operations.

Yet when you're managing your own money, you only pay fees on transactions. You don't have a staff, and -- if you buy with the intent to hold for the long term -- you incur minimal transaction costs. Which brings me to the final edge...

5. You've got time. The biggest edge an individual investor has is that time is on their side. They can buy a stock today -- and hold for decades, without worrying about any external pressure to sell, as is common on Wall Street.

Often, you've got a goal in mind: retirement, kids' college fund, new home. And, more often than not, these are many years out in the future.

And although stocks are fickle in the short term -- jumping up here, dropping off a cliff there -- over the long term, the market's trajectory is consistently up. In fact, my Motley Fool colleague Morgan Housel recently calculated that an investor who bought and held over a 20-year period had positive returns 100 percent of the time! He calculates that the worst someone's ever returned over a 30-year period is a 250 percent gain, post-inflation.

Those are returns I think all of us could get behind.

So as you can see, being a small investor looking out for your own best interests is a critical edge you have over Wall Street.

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5 Things That Give You an Investing Edge Over Wall Street's Big Guns

Warren Buffett is a great investor, but what makes him rich is that he's been a great investor for two thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.

Most people don't start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That's unfortunate, and there's no way to fix it retroactively. It's a good reminder of how important it is to teach young people to start saving as soon as possible.

Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That's really all there is to it.

The dividend yield we know: It's currently 2%. A reasonable guess of future earnings growth is 5% a year. What about the change in earnings multiples? That's totally unknowable.

Earnings multiples reflect people's feelings about the future. And there's just no way to know what people are going to think about the future in the future. How could you?

If someone said, "I think most people will be in a 10% better mood in the year 2023," we'd call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.

Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97% return by the end of 2012. That's great! And they didn't need to know a thing about portfolio management, technical analysis, or suffer through a single segment of "The Lighting Round."

Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7% of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96% total return -- still short of an index fund.

Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it's not like golf: The spectators have a pretty good chance of humbling the pros.

Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time -- every single time -- there's even a hint of volatility, the same cry is heard from the investing public: "What is going on?!"

Nine times out of ten, the correct answer is the same: Nothing is going on. This is just what stocks do.

Since 1900 the S&P 500 (^GSPC) has returned about 6% per year, but the average difference between any year's highest close and lowest close is 23%. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring.

Someone once asked J.P. Morgan what the market will do. "It will fluctuate," he allegedly said. Truer words have never been spoken.

The vast majority of financial products are sold by people whose only interest in your wealth is the amount of fees they can sucker you out of.

You need no experience, credentials, or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he'll receive, even though it makes him more likely to be wrong.

This is perhaps the most important theory in finance. Until it is understood you stand a high chance of being bamboozled and misled at every corner.

"Everything else is cream cheese."

Adam Wiederman is a Motley Fool contributing writer.
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