Why Small Investors Have the Upper Hand
An analysis of why small investors can achieve better returns than institutional players.
10 minutes
This week I questioned the idea of a smaller investor being able to achieve higher returns than large asset managers.
I started to think about this after a friend, let’s call him Daniel, asked me how I hoped to find opportunities in an industry dominated by institutional investors with much greater resources than me. With all of their analysts and MBAs, it seemed to him that the quest to make a living out of finding undervalued companies was not worth pursuing.
After careful analysis, I came to the conclusion that smaller investors have an advantage over large asset managers. Paradoxically, size is a limiting force. The more capital an investor manages, the harder it is to generate a return. Let’s dive in.
Capital Constraints
Smaller investors are more likely to find an attractive investment opportunity. In simple terms, they can fish where the fish are, and where no fishermen are near.
Asset managers and institutional investors have a handicap over smaller investors because their potential opportunities are smaller. In investing, as you manage more capital, the fewer things you can invest in, and the harder it is to compound return at a high rate.
Today the majority of the capital invested in the markets is institutional and passively indexed. According to Investopedia, institutional investors account for about 80% of the volume of trades on the New York Stock Exchange.
This means that most investors are looking at the same things. They are all trying to catch fish in the same place and with the same constraints. Because of their size, most institutional investors need to invest in companies above $1 billion in market cap. This opens the door for the smaller investor to take advantage of opportunities in overlooked companies, resulting in higher potential returns. Â
Mis-Aligned Incentives
As a small investor, you do not have misaligned incentives. You eat your cooking.
Most institutional investors earn management fees. This creates an incentive to raise more and more capital from new investors. As a result, 2 things happen: First, potential investment opportunities continuously narrow because of the increase in AUM; Second, more time and attention is spent raising new capital than looking for attractive investments, leading to poor investment results.
Group Think
It is easier for small investors to have an independent mind.
A lot of investment opportunities are contrarian by nature. An investor understands something that the market as a whole does not, which when materialized, results in a successful investment. Asset managers hardly take contrarian positions for their own preservation. No one will get fired for mistakenly investing in Apple, however, one might get fired from investing in an unknown company.
Short-Term Thinking
Small investors can be patient and have a long-term time horizon without the risk of losing their jobs.
Institutional investors and asset managers are judged quarterly and even monthly. If their returns fail temporarily to meet the index, then their jobs can be at risk, or investors can withdraw their funds. This results in a short-term investment mindset and an inability to think long-term and have the patience to wait for attractive opportunities.
Institutional Requirements
Lastly, small investors are not plagued by requirements that negatively affect potential investment returns.
Institutional investors are required to diversify their positions excessively, which reduces investment returns because more capital is placed on the worst investment ideas.
Moreover, institutional investors are often prohibited from investing in companies with small share values and market caps, or that operate in controversial industries.
Summary
In summary, I believe small investors have the upper hand in the game of investing. Small investors can access an array of greater potential investments, and take better advantage of market inefficiencies.
What do you think?