“I’ve seen an agent punch through a concrete wall; men have emptied entire clips at them and hit nothing but air; yet, their strength, and their speed, are still based in a world that is built on rules. Because of that, they will never be as strong, or as fast, as you can be”  Morpheus speaking to Neo in The Matrix

Like Neo in the Matrix, retail investors often believe themselves powerless against the machine.  Surely with all the resources available to large institutions, it’s futile to compete against Wall Street?

This couldn’t be further from the truth.  What many people don’t realize is that institutions are constrained by a set of rules that they themselves have created.  Many professional investors are so comfortable living inside the constraints of this world that they rarely stop to contemplate their lack of freedom – they are slaves to their own system.  Others are aware of the rules, understand that they might perform better outside of these constraints but place career stability over performance (the ‘cynics’).  Then there is a third, much smaller group: Independent thinkers who are brave enough to stand apart from the crowd.  This group is characterized by gurus such as Warren Buffett, Seth Klarman or Bruce Berkowitz.  These people celebrate the presence of the ‘slave’ and ‘cynic’ class – and they use the existence of a rule-based world against them.  One of the greatest things about being an individual investor is that you too have the same freedom to act in this way –  and to take advantage of the system.  But to do this you must first know the system and its flaws.

“Let me tell you why you’re here. You’re here because you know something. What you know you can’t explain, but you feel it. You’ve felt it your entire life, that there’s something wrong with the world. You don’t know what it is, but it’s there, like a splinter in your mind, driving you mad.”

1. Obsession with the short -term

In my experience, the most damaging constraint faced by fund managers is a relentless focus on short term performance.  A fund manager who is obsessed with a good quarter has no freedom to look beyond that quarter or to make decisions which are sensible in a long-term context.  Many professionals act this way because of the intense pressure they are under to constantly perform; they feel tethered by quarterly reviews from the CIO, from consultants and from clients.  Ultimately, all this achieves is mental exhaustion on the part of the fund manager and an equally unsatisfying experience for the client.

“The great majority of institutional investors are plagued with a short-term, relative-performance orientation and lack the long-term perspective that retirement and endowment funds deserve.  Myriad rules and restrictions, often self-imposed, also impair the ability of institutional investors to achieve a good investment result”  Seth Klarman, Margin of Safety

2. Institutional Bureacracy

Klarman brings us nicely on to the second point.  Institutions impose all manner of rules and restrictions, ostensibly to manage risk and ensure a degree of control over PMs.  However, the unintended consequence is that the PM is unable to pursue alpha wherever they see it.  The issue is exacerbated by a slow decision-making process, which makes it difficult to take advantage of time-sensitive opportunities.

3. Failing Conventionally

“Worldly Wisdom Teaches us that it’s better to fail conventionally than to succeed unconventionally”.  John Maynard Keynes.

Above all else, professional investors worry about being made to look stupid in front of their colleagues, to loose respect and possibly their jobs.   This generates an incentive to be risk averse in situations where conventional wisdom argues for caution (and equally to take bigger risks when the market is bullish). Toward the end of June 2010, it was hard to find an institutional manager who would countenance the idea of going long BP because of heightened fear over the impact of the Macondo Oil Spill (regardless of how low the share price fell)

I remember a senior fund manager once telling me “I always try to sniff which way the market is going, and then I ride it”.  The only thing I sniffed was BS (and not a little desperation).  I’ve rarely seen anyone consistently outperform by trying to follow a crowd.  Buffett takes advantage of this mentality with his simple wisdom “Be greedy when others are fearful and fearful when others are greedy”

4. The Need to ‘Do Something’

Institutional investors often confuse work with activity.  They want to show that they are “actively managing” the portfolio by churning it on a regular basis.  Of course new and interesting ideas are always desirable, but churn for the sake of churn often leaves the manager with high transaction costs and a poor understanding of what he or she holds.

5. Unnecessary Diversification

Modern Portfolio Theory still holds sway on Wall Street, and many institutions feel the need to have a high level of diversification to demonstrate to clients that they are ‘risk aware’.  This often leads to managers running portfolios with 100+ stocks.  There is little benefit from this degree of diversification and, in my experience, it guarantees two things: Returns which are close to benchmark and a manager who can’t keep track of all the ideas in the fund.

“Diversification is protection against ignorance, it makes little sense for those who know what they’re doing”  Warren Buffett

It’s not surprising to learn that many of the investment greats choose to distance themselves from the Wall Street machine, both mentally and physically – Buffett has lived his entire life in Omaha, Nebraska.  Bruce Berkowitz moved from New Jersey to Miami to be further from the noise.  When I see investors glued to CNBC or desperate to get the opinion of the latest Wall Street analyst it makes me depressed because they are allowing themselves to be enslaved by the system.

“If the behaviour of institutional investors weren’t so horrifying, it might actually be humorous”  Seth Klarman, Margin of Safety

Being a great investor and generating above-market returns is not an easy task.  It takes a lot of work, strong analytical ability and emotional discipline.  I come across many individual investors with these characteristics, but they are too easily intimidated by the existence of  ‘professionals’ in the market.  It took me a while to understand that the presence of large institutions is usually an opportunity for the individual, not a threat.  Just like Neo, once you recognize the system for what it is, you can free your mind!

“I’m trying to free your mind Neo.  But I can only show you the door.  You’re the one that has to walk through it”

Join the conversation! 6 Comments

  1. Nice article. Do not try and bend the spoon. That’s impossible. Instead… only try to realize the truth … there is no spoon.

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  2. Thank you! I’ve been on a rant about what I refer to as the Financial Industrial Complex ever since I found my mutual fund returns (for my childrens’ education funds, no less!!) were coming in at a paltry ~1% (over 17 years!!!).

    “But I’m much better now”

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  3. […] have a look at Thomas Beevers post Why the Individual can Beat the Institution Every Time; for all my ham-fisted rants, it is comforting to have an industry insider cite the common reasons […]

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  4. […] This is putting pressure on asset managers to move away from “closet beta” and demonstrate outperformance. Most of them, however, are struggling to re-engineer their operations for this new world. Having been a fund manager for over 10 years, I know that these institutions are not environments that are conducive to alpha generation. The philosophy of most professionals is that it’s better to fail conventionally than succeed unconventionally. Institutional bureaucracy, excessive diversification, and a fixation with career risk work together to encourage benchmark hugging. On top of this funds find it hard to invest in smaller-cap stocks, where many of the best opportunities are to be found. Most asset managers are happy to sit back and “go with the flow”. In 1995 this was fine and fund managers could enjoy a nice long career without any downside. In 2015, it’s not OK. (I have written more about the constraints of an institutional environment here) […]

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  5. Great article. I have offered similar explanations in my recently published book. Question is how to deliver this message to individual investors in a format that has a chance to go viral, before Robo advisors shift the debate in a completely different direction!

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