In fact, the little guys will always outperform the professionals, so long as they don't try to compete

590 wall street traders REUTERS Brendan McDermid.jpg

To many, the prosecution of hedge fund chief Raj Rajaratnam was final evidence that the glory days of the small individual investor had passed. We already knew that amateur investors lacked the resources to match the research efforts of sophisticated institutions and hedge funds. The rise of automated trading systems that continually scan the markets and trade in time frames approaching microseconds introduced another dimension to the market that was well beyond the reach of individual investors. Then, we learned that well-connected hedge fund managers were paying for market information in surreptitious deals of which individual investors knew nothing at the time.

It is not surprising that many individual investors, and many pundits as well, concluded that the best course of action was to put one's money with a sophisticated hedge fund or go home. Amateurs could no longer possibly compete effectively in the modern marketplace.

Such views, though intuitively appealing, turn out to be completely wrong. In fact, if individual investors accept their limitations and act wisely, they will always outperform active professional investors on average! Furthermore, this surprising conclusion does not depend on complex economic arguments involving market efficiency or rationality: it is a direct result of basic arithmetic. A simple example illustrates why amateur investors should not despair.

Take all stock market investors and divide them into two groups: passive and active. The passive group is composed of individual investors who conclude that they possess neither the information nor the skills to compete with active professional investors. These passive investors buy an index fund designed to match movements in the market as a whole. Such funds are available at very low cost, because no active management is required. The active group consists of everyone else, but is composed primarily of active professional investors.

Now suppose in a given year that the market rises by 10%. The index fund, by construction, matches the market so passive individual investors earn 10%. But if the market goes up 10% and the passive group earns 10%, then the active group must also earn 10% because the market consists of active and passive investors.

For the active investors, however, this 10% does not include expenses. Active investing isn't cheap. These investors design and implement expensive computers systems, hire sophisticated traders (who get paid many millions of dollars), and/or pay people for inside tips. When these expenses are netted out the active group as a whole must earn less than 10%.

In other words, the professionals as a group must always underperform passive amateurs as a group. This holds whether the market rises or falls and whether the market is responding rationally or emotionally. The small individual investors as group will always outperform the Wall Street titans as a group, after expenses.

It should be stressed that this conclusion holds on a group-wide basis. Within the group of active investors, some will most likely have done much better than 10% (before expenses) and others much worse. If an individual investor ventures to enter the world of the active traders, then he or she will likely be part of the poorly performing subgroup due to the advantages sophisticated investors enjoy.

This analysis makes clear that the threat to the individual investor is not being in the market, it is actively playing the market. Small investors who passively hold a portfolio indexing the market can be assured that they will outperform active investors overall. However, should they decide to become active themselves, all bets are off. In this respect, fictional police officer Dirty Harry had some sage investment advice: "A man's got to know his limitations." If amateurs accept their limitations, stocks continue to be a wise investment.

Image Credit: REUTERS/Brendan McDermid

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