Investor Vs Fund Manager

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A fund manager relies on research and processes to pick winners, the DIY investor has only luck to fall back on

 

Despite the good long-term track record of equity funds, several people think they can make more money in the equity markets on their own. It is not known whether any of these do-it-yourself (DIY) investors actually set themselves exacting standards for beating the market index. It is, however, interesting to find out about their motivation.

There are three broad components of investment performance. The first is access to information and the ability to analyse it. The second is the need to have a process for constructing a portfolio. The way we choose from the universe of stocks, the filters that we apply to shortlist them, and the manner in which we allocate money to construct a portfolio, is a process. The third component is the ability to identify and exploit market inefficiencies. In an efficient and rational market, buyers and sellers would know beforehand the price they are willing to pay. A sustained fall in price that does not motivate buyers to step in, and only increases the number of those keen to sell, or a rise in price that brings in more and more buyers is a market inefficiency. Here, several distortions can ensue, making it possible to generate money.

Investment research firms have rigorous fundamental analysis. The best ones employ specialists who know the structural nuances of sectors. Working with published information about businesses, grasping the complexities of their finances, engaging with the management to verify their claims about the future require knowledge, skill, time and money. There are some devout groups of investors who meet and discuss stock ideas and invest on the basis of their research. Except for this small minority, most of the DIY investors may not have seen or read even a single annual report. Poor selection skill is a serious problem.

As for the investment process, there are investor groups that try to create one. In a recent conversation with financial advisers, I asked them whether they had replicated a selection process for mutual funds, even as they questioned fund managers about performance and processes. Not one of them had come even close to a process-driven investment style. Many of them, however, owned stocks, and their investors also had stocks. It does not seem important to several DIY investors to think of a process when they buy stocks. This is why they end up with portfolios that have too many stocks with too little allocation to each. They hold losing stocks without getting rid of them, or hold too many mid- and small-cap stocks, avoiding established names that feature in the Nifty index. The lack of investment strategy and process hurts DIY investors, but they are mostly oblivious to it.

What then is the source of confidence for the DIY investor that he will do better than a fund manager? A large majority of the DIY investors tends to lean on market inefficiencies. However, not all of them exploit these inefficiencies. A good number falls prey; the others make a killing. The trouble is that these losses and windfall gains are random, retaining the interest to try their luck at a very high level.

Investors seek the short-cut of a few thumb rules, actively seeking information about buying and selling. We see this manifest in so many ways. An IPO that is able to whip up media interest gets subscription since investors think that all the buyers who are queuing up cannot be wrong. We see trading interest in stocks in which the volume of trading has gone up due to insider activity. There is a keen interest in media commentaries, expert views, and stock recommendations so that trading activity can be aligned to the views expressed.

Informed investors are also aware of the inefficiencies. The fund managers who compete with one another may lean on solid research and defined processes. However, they are well aware that these can be replicated by the competition. If they did not stick their necks out to take a view, to generate an idea, to call a stock, they would all deliver average
performances. It is when they are able to use their judgement to identify what is, from what it may seem to be, that they take different portfolio positions and end up with outperformance. They have the solid foundation of research, information and process, before they layer it up with their ability to spot a winning opportunity.

There is a difference in approach when it comes to inefficiencies. Some investors may end up losing as they are a part of the problem. Other investors may make money by being contrarian and staying out. The problem is that both the fund managers and retail investors are prone to this double-edged sword. The gains are mostly by default, not design, so they cannot be replicated. That is why the same fund manager does not make money all the time; some calls go wrong anyway. However, he has the solid grounding of information and process that will rein him in. He can rebalance his portfolio and come back in the game. The simple investor, who claims to beat the manager at his own game, has nothing but luck to fall back on.

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