5 things professional investors do that you shouldn’t

We turn to others for cues and norms that govern our behaviour and actions. As social beings we crave acceptance and tend to mimic behaviour to gain de facto approval. As investors we often turn to the professionals for guidance.

Perhaps the age of the rockstar portfolio manager is over. But that doesn’t mean the media is not filled with professional investors opining on their latest picks and how they are positioning their portfolios for the interest rate, economic and geo-political forecast du jour.

Many investors take these views as a guide for managing their own portfolio. The professionals are educated and experienced. They have time to study markets – it is their job after all. And they have help from teams of analysts along with the best data and research to help them make decisions.

Some investors look at these perceived advantages and figure there is no point in even trying. They just give up and declare investing rigged.

I’ve got a different perspective than both groups. I think trying to copy what professional portfolio managers do is the worst thing an individual investor – or adviser for that matter – can do. I think that we humble individual investors have advantages over professionals. By trying to follow the lead of professionals we give up those advantages.

Professionals are not stupid. They are simply reacting to the structural impediments of their profession. Some of these structural impediments are imposed by regulatory authorities. Some by internal risk management rules. Some are imposed by investor behaviour. Some by compensation arrangements.

I think most professional investors would admit that they would have better performance if these structural impediments went away. And some of the best professional investors have found a way to remove these impediments. That is why we have hedge funds with less regulatory oversight, wider investment mandates and lock-up periods for capital to lower the impact of fickle investors.

I’ve outlined 5 things that professional investors do that you should avoid. Not doing these things ensures that you don’t inadvertently give up your long-term advantages as an individual investor.

Focusing on the short-term

Every fund manager says they are a long-term investor. The data suggests otherwise. There are structural impediments to the job which encourages fund managers to focus on returns over the short-term. The primary reason is that fund managers are forced to deal with fickle investors who punish and reward short-term performance by bouncing from investment to investment. This impacts the way fund managers invest.

It becomes harder to have the patience to wait out periods when an otherwise great company faces temporary headwinds. Patience may be the right thing to do but it might mean there will be a lot less investors left in the fund when the company turns around.

There is nothing stopping you from being a long-term investor. Nothing except your own bad habits. A long-term focus minimises taxes and lowers transaction costs. Holding great businesses for the long-term allows you to benefit from the wealth generating impact of a great business compounding internally invested funds.

Professional investors may constantly churn their portfolios. Individuals do that at their peril. Professors Barber and Odean at the University of California at Berkely studied 66,000 trading accounts at US broker Charles Schwab. If turns out the investors that traded the most underperformed the market by 6.5% a year over a 5-year period. Take advantage of the lack of structural impediments and focus on improving your behaviour. You can afford to be patient. Use it to your advantage.

Equating volatility and risk

Professional investors conflate risk and volatility. The definition of risk according to the Cambridge Dictionary is “the possibility of something bad happening”. In the professional investing world the “something bad happening” is volatility. Volatility is prices – or the value of a portfolio – bouncing around.

When I think about “something bad happening” to my own portfolio it is not volatility that I’m worried about. My portfolio does not exist in a theoretical world. My portfolio is made up of assets that I want to sell in the future to pay for things I want and need. That means my risk is not having enough money in the future to pay for what I want and need. I think for most investors risk has little to do with volatility.

Why the difference? A big part is informational asymmetry. A portfolio manager with retail clients doesn’t know anything about any of their investors. They don’t know the goals of the people they are investing for or their timelines. Therefore, they define high level parameters for volatility and return targets for a portfolio. It is up to the end investor or intermediaries like an adviser to align goals with the right types of investments.

I have no issue with this approach. It is the best we can hope for in an imperfect situation. But knowing what I want to accomplish and when I want to accomplish it provides me with a huge advantage over a fund manager. I can design a portfolio that is right for me. I can worry about volatility when volatility is actually a problem like when I am approaching retirement. I can consider my investments as part of my holistic financial situation. This means I can focus on the real risk of not achieving my goal.

Not caring about taxes

Incentives should be aligned to the results we want somebody to achieve. This is self-explanatory. And most professional fund managers have incentives aligned to the returns that they achieve. Those returns are calculated according to industry standards, verified by third parties and publicly published for regulated funds.

The returns represent the track record of fund managers. Strong returns generally lead to more money being invested in the funds. The fund company makes more money. And in most cases the fund manager will make more money. Those are aligned incentives.

The purpose of my own portfolio is to grow my savings at a rate higher than inflation so that I can buy more with the money I’ve chosen to save. Taxes play a large part in this because I plan on spending the money. As previously stated, the rate of return that matters to me is the after-tax return in excess of inflation. This can be significantly different than the headline returns published by the industry. My colleague Shani compared published returns with what investors get to keep. It isn’t pretty.

In a practical sense what this means is that I invest very differently from most fund managers. Selling an appreciated position because I think another idea is better has consequences. The hurdle rate for the new investment needs to be higher.

An example is illustrative. If I sell company A which I purchased 6 months ago with a cost basis of $10,000 and a current value of $20,000 I owe taxes of $4,500 at a 45% marginal tax rate. That means that the new investment I buy with the proceeds needs to outperform the old investment by 22.50%. That is a tall order. A fund manager wouldn’t have to make this trade-off.

It also means that holding periods matter. The 50% capital gains tax discount for holding a share for longer than a year is meaningful. Turning over a portfolio to the degree most fund managers do makes little sense for an individual investor.

A constrained set of investments

Have you ever been to an investment conference where fund managers feature as speakers? First the value manager speaks about how great current the opportunity is for value shares. The growth manager follows with a presentation on how the best opportunities can be found in growth shares. Next is emerging markets, high yield bonds, private credit…you get the point.

Most fund managers have a narrowly constrained universe of investment opportunities they are allowed to invest in. It isn’t surprising that fund managers would champion the particular investment opportunities they focus on. Most of the managers are articulate and smart which makes their pitches compelling. There is also a particular decorum to these events and managers will rarely disagree with their peers. It can be confusing for individual investors to follow. There are benefits to diversification but at any given point in time everything can’t be an opportunity.

Diversification also hides the fact that while there are many ways to successfully invest there may only be one way that works for you. Your own circumstances and goals mean that some investments are best left out of your portfolio. And your own viewpoint and temperament mean that you will be drawn to certain types of investments. And that is ok. Your increased conviction will make it more likely that you will hold for the long-term which is a larger contributor to success than holding every investment under the sun.

I’m an income investor. This approach means that my portfolio is not going to contain small-cap growth shares that don’t pay dividends. There is nothing wrong with investors that buy small-cap growth shares and many are extremely successful. It just means that approach isn’t right for me. I have no intellectual connection to that type of investing. I don’t think I have a competitive advantage in that space.

Don’t get sucked into thinking everything is an opportunity. Investing success is about sticking with a strategy over the long-term. It is about following an investment strategy that aligns with your competitive advantage as an investor. Diversify away single security risk but don’t feel like you need to own every asset class with a compelling pitch person.

Constantly rotating a portfolio

I’ve been lucky enough to go on safari in Africa. One of the most compelling safari experiences is witnessing the great migration. Huge herds of animals travel great distances across the African savannah in search of food and water as seasonal conditions change. This is a perilous journey as predators wait to pick off members of the herd. Yet they are compelled to embark on this high-risk endeavour to survive. This is a bit like how many fund managers invest.

As interest rates change, the economic cycle progresses, and geo-political environments change fund managers set-off on the great rotation. This can be within narrowly constrained portfolios or within a wide mandate giving a portfolio manager wide discretion. The explanations for this great rotation sound compelling. Certain types of investments or asset classes perform differently in different environments.

Much like the great migration this journey can be perilous. A fund manager can’t wait until the actual event occurs. Rotating into investments that may perform better in a lower interest rate environment must be done before interest rates are lowered. You need to get there first which means that you need to predict what is going to be happen before everyone else. This constant need to be right is really hard to do. As managers make mistakes in the rotation game they can get picked off like a poor wildebeest struggling across a croc filled river.

Most fund managers need to play the rotation game because underperforming over the short-term can lead to outflows. As a long-term investor you have no pressure. There will be periods where you underperform because your investment strategy falls out of favour or because a great company goes through a rough patch. This is no impediment to achieving your goals. Constantly rotating a portfolio may seem like a nimble approach to changing market conditions. In reality it is likely just a way to pay more taxes and lower your returns. Don’t play this game.

Final thoughts

Fund managers fixate on investments. You shouldn’t.

A fund manager’s job is to pick investments. Your job is to achieve your financial goals. Those are two very different things. Success for you is generating sufficient after-tax, after-fee and after-inflation returns to meet your objectives. Success for them is to beat a benchmark.

Investments are a means to an end. Investing is a holistic process that takes into account your specific goals, your personal circumstances and tax considerations to name just a few of the many inputs. There is a significant body of research that shows picking investments in your portfolio is the least impactful component of your financial outcomes. My colleague Shani wrote a great article explaining how she has incorporated this approach into her own investment strategy.

Let the professionals try and navigate the structural impediments to their jobs. Let the media breathlessly cover each of their brilliant sounding strategies. Just play your own game. Control what you can control. Take advantage of the benefits of simplicity. I bet you will turn out in a better place in the end.

I would love to hear your thoughts and questions. Email me at mark.lamonica1@morningstar.com