Why the Market Is Not Stacked Against the Little Guy

Institutions such as Goldman Sachs have many advantages over individual investors, but sometimes the little guy has the edge.

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The picture painted by former Goldman Sachs executive Greg Smith, whose incendiary resignation letter was published in the New York Times last week, is one in which big Wall Street firms regularly ignore their customers’ best interests. This accusation hardly comes as a surprise to most Americans, who are suffering in a damaged economy that they blame – to one degree or another – on Wall Street’s excesses and irresponsibility. The question that naturally follows is whether individuals ever have a fair chance in the stock market, or whether the game is totally rigged in favor of insiders.

Professional investors have an obvious edge in many ways, but surprisingly perhaps, in the aspects of investing that matter most, individual investors can compete effectively — and even have certain advantages of their own.

To understand why, it’s essential to distinguish between two different types of investing. The key is to look at where the profits come from. The first type is short-term trading, which is a zero-sum game – a successful trader’s winnings come mostly from the money that another trader loses. Small investors can’t compete with institutional investors in this arena. The pros watch the stock and bond markets continuously and can respond faster than individuals. They have access to the best available sources of information. And their trading costs are lower. In addition, they have some less savory opportunities, such as misusing private information, exploiting quirks in trading systems, misrepresenting investments they sell, and creating incomprehensible products.

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The second type of investing consists of participating in the long-term growth of the economy through stocks and some other financial assets that can outpace inflation over long periods of time. And here it’s institutions that are at a funny kind of disadvantage. For starters, they have high overhead – expensive office space, fancy equipment and big salaries. But they also have a more serious problem: Apart from a few specialized money managers who take a value-oriented approach and are able to wait several years for their investments to pay off, most pros have to show quarter-to-quarter performance that keeps up with the major market indexes.

Having a large group of market participants who are all trying to beat the market in the short run produces distortions or enforces biases. It causes some shares to become overvalued and creates buying opportunities for others. Moreover, even if the pros realize they are doing this, they can’t avoid it, because their bonuses are based on short-term performance.

Individual investors can benefit by simply avoiding the areas where the uneven playing field most favors the pros, and by concentrating on those where the pros are victims of their own short-term biases. Fortunately, the types of investing that are most favorable to individuals are also those that are most important for meeting long-term goals such as retirement. Indeed, time-tested conservative investing principles succeed precisely because they take advantage of the distortions created by institutional investors.

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Here’s a list of some of those principles, why the pros are biased against them, and how the rest of us stand to benefit:

Simpler investments are safer. Exotic or obscure investments give the pros their greatest chances to benefit from superior information. The 100 or so largest U.S. companies are widely followed and their common shares are least susceptible to manipulation.

Long-term time horizons offer better opportunities. Because the pros typically need investments to pay off in six-to-nine months, they gravitate toward stocks that are already on the upswing. Out-of-favor stocks might be able to provide bigger returns over a three-to-five-year period.

Dividends are generally underrated. To avoid the risk of underperforming the indexes, pros have to focus chiefly on opportunities for capital gains. Few portfolio managers want to earn a safe 4% annual yield but be up only 10% in a quarter when the Dow is up 20%.

Inflation protection tends to be overlooked. Few professional investors boast of their inflation-adjusted returns. Their bonuses are based on profits in current dollars. So oil stocks, for example, which offer some degree of long-term inflation protection, may not receive the premium they deserve.

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Minimizing costs is the key to superior long-term returns. Investing fees are higher than they look. For a portfolio that averages 6% a year after inflation, it makes a big difference whether annual fees are one percentage point or only one-third of a point. A buy-and-hold approach to blue-chip stocks will hold down costs. (For diversified investments, an index fund will almost always have lower annual costs than a managed fund.) And while the pros generally can’t take a buy-and-hold approach, the rest of us can.

In a way, the biggest advantage individual investors have is that they can pick where they are going to compete – and that means avoiding the kind of investing where the pros have their greatest edge and focusing instead on strategies that benefit from flexibility and patience. Even if Wall Street sharks refer to individual investors as muppets, there’s little they can do that will affect the long-term returns of a portfolio of well-chosen blue chips.

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