Private investors are lagging far behind the return of the overall market. The reasons are worth discussing.
According to a recent study, private investors are lagging far behind the return of the overall market. While the market achieved an annual return of 8.7%, the return on the portfolio of private investors was only 3.1%.
This I have recently read in a German daily newspaper.
The article stated, that short-term thinking and greed are some of the mistakes, many investors are making. On this, I agree. On other stated mistakes I disagree. Looking at them as mistakes is more the reason why private investors achieve mediocre returns, than making them.
The first alleged mistake, that private investor make, is lacking diversity. The author of the article argues that diversification is the most important requirement for successful investment. I can only clearly disagree.
Usually a very long list of securities is not a sign of the brilliant investor, but of one who is unsure of himself. (Philip Fisher)
Wide diversification is only required when investors do not understand what they are doing. (Warren Buffett)
Whoever spreads his investments too much, in different assets or different stocks, can only achieve mediocre returns. The wide spread compels us to invest in medium to bad companies. There is no unlimited number of outstanding companies on the market. You cannot just find them by the way. You have to search for them. But most investors do not even make this effort. They choose a stock according to the recommendation of any investment advisor without having researched the company.
The outstanding investor Peter Lynch claims that people would take more time to purchase a microwave than to choose a good investment. I can only agree with this claim.
If you have 50 or more stocks in your portfolio, as a small investor, you are not able to make a sound assessment of the company and try to find out if it is an outstanding one that promises a great return. Those who work 8 hours a day do not have the time researching so many companies. So your decision has to rely on the little informations you can find easily. These less informations usually do not give you the right hints, which are needed for a good and intelligent investment decision. So, it is understandable that your performance suffers.
Losses don’t come from a lack of diversification
The reason for the lack of return is therefore not a lack of diversification of one’s own portfolio, but a lack of knowledge about the company that one gets with the stock. If you buy mediocre companies, you only get mediocre returns. In addition, the price you pay is often too high. Anyone who buys too expensive has to expect losses.
Philip Fisher commented diversification as follows:
“He who has a long list of possible securities shows less his brilliance than his uncertainty.”
And Warren Buffett adds:
“Broad diversification is only necessary if investors do not understand what they are doing.”
Knowing companies is the solution to this alleged investment mistakes, not a broader diversification.
The second alleged mistake referred to is the so-called „stock picking“, which means the targeted investing in individual companies. Anyone who has wrongly picked – and who is not sufficiently diversified – has a so-called “lump risk”, which means an overweighting of individual assets in the depot. This „lump risk“ diminishes the long-term successful development of the hole depot.
The worst thing you can do is to buy more of that stock when the price is falling only to lower the purchased price with the hope that prices will rise again.
This second mistake is also based on a lack of knowledge about what is going to be put into the depot. Surely the author is right in some way: to pick stocks without researching a company as deeply as possible and without paying attention to excellent figures in the financial statement, cannot promise any success. But if you are looking specifically for outstanding companies – which can also be found by private investors – then this targeted picking can outsmart the market.
Private investors are underestimated
When you are lucky, and the market declines, you have the possibility to get a great company for less, maybe buy even more later more cheaply. Then there is nothing which can stand my return. Because purchasing outstanding companies at a bargain is the right path to excellent returns. And it is increases the security.
I think, the author makes a mistake himself when his thesis implies that a private investor cannot make a meaningful and intelligent investment decision. Because this is what stands behind the claim that stockpicking is one of the mistakes when investing. This assumption leads the author to his recommendation of different ETFs as a solution for all investment mistakes.
ETFs are certainly not a bad solution for the one or other investor, especially for those who do not feel taking care of his assets. However, ETFs cannot beat the market. More than the aforementioned 8.7% would not be possible. And only if you invest in the right ETFs.
However, if you want to take care of your own assets, you have to invest actively. With the right requirement anyone is able to do so.