Future Focus: The risk of institutional thinking in personal portfolios
Where we have a one up over professionals, and where we need to be cautious.
J.P Morgan CEO Jamie Dimon recently shared that he wakes up at 4:30am every morning and reads 5 papers. Many of us have similar rituals. We wake up, check our preferred media outlets, and perhaps check how our portfolio has done overnight. Some of us have push notifications during the day that pull us back into the news cycle. Rinse and repeat each day.
As investors, we tell ourselves we are staying up to date with what’s impacting markets, and in turn our portfolio. Many are constantly on the lookout for new opportunities. Who we go to for guidance matters. It is often professional money managers.
They are investors that take care of millions of dollars and many purely focus on one asset class. Professionals often have bonuses based on how they perform against a market benchmark. A lot of them are fantastic storytellers and they can clearly articulate their conviction in a particular opportunity. They may conveniently fail to mention this once in a lifetime opportunity makes up 1% of their portfolio. Yet, we continue to consume this institutional thinking and apply it to our personal portfolios.
Here’s where individual investors are different and why this difference is important.
You’ve got a one up on professionals
Peter Lynch is as close as you can get to a superstar in the financial world. He managed billions of dollars in Fidelity’s Magellan Fund and wrote One up on Wall Street to share his security selection process with the world.
Peter believes individual investors have ‘one up’ on professional investors – that individuals have proximity and understanding of the companies that they are investing in. They can often spot opportunities with companies before professional investors do.
He also speaks about the importance of ignoring the endless news cycle on market movements, interest rates and economic data. This is a particularly relevant lesson in this current environment.
I attended a lunch that brought together arguably, some of the best economists in the country into one room, including a former RBA Governor. They took turns talking about their forecasts for the next 3-6 months and the seriousness of the economic situation that we were in. I don’t disagree that interest rates, unemployment rates and low wage growth causes many people stress, anxiety and suffering.
I anxiously waited for my turn to say that little of this factored into my work with long-term investing.
In 20 years, the timing of a 0.25% increase to interest rates will have no impact on your portfolio. The impact of short-term movements for long-term investors are generally irrelevant. It may concern professionals because it is their job to be concerned. It should not concern you.
The advantage that individuals can gain by focusing on the long-term has a technical name. It is called structural edge. Structural edge is an advantage gained when there are no constructs that govern the way an investor goes about the investing process.
Professional investors have restrictive constructs. Their career progression, compensation and business goals ultimately influence the way that they invest. They have competing priorities. They are trying to support the company they work for and maximise their compensation. Sometimes, these two disparate influences align and induce wise investing decisions, and sometimes they don’t.
Professionals certainly have some advantages over individual investors. Getting paid to do a job and charging other people for that job means they must meet standards around education and experience. They all have support from other professionals, time to dedicate to the pursuit of investing and access to tools and data. It also comes with pressure to perform over short periods of time to maximise compensation and limit career risk.
Institutions and professional investors have a different approach to individual investors, so it is important we heed their advice, tips and insights with this context in mind.
The difference in portfolios
Perpetual vs finite capital
Investing serves a different purpose for individual investors. We want our investments to cede at some point, where we are able to enjoy the fruits of our labour and sacrifice to better our lives. Our portfolios must reflect this fact.
Professional investors operate on the assumption that the fund will continue into perpetuity, and they make investment decisions based on this. There are some endowment funds and sovereign wealth funds that operate with centuries as their time horizon. There’s no glide path to the end of a financial goal. They do not need to account for retirement spending, short-term volatility and they have a different perspective on cashflow management. This means that their approach to risk in the portfolio is different to ours.
For this reason, asset allocation can vary drastically. The large amounts of capital teamed with the perpetual timelines mean that they can maintain exposure to hedge funds, alternative assets, private equity and real estate.
We have the opportunity to think long-term
Investors have no restraints that prevent a long-term focus. Just like there are different types of investors, there are different types of professional investors. Many fund managers say that they are long-term investors, but a lot of these professionals operate in an environment that structurally discourages this. Many professionals are under pressure to outpace or at least match their peers over one-year periods – or shorter. If they fail, the investor money walks.
In a study Morningstar conducted of US domestic equity funds, it was found that the turnover rate was ~63%. That means that the average holding period for stocks in that fund was 19 months. This certainly does not meet the definition of long-term investing and the transaction costs and distributed capital gains that eat into investor gains.
Individual investors don’t have any structural impediments to being long-term investors except their own lack of patience.
After-tax and cost returns
Professional investors are judged on the performance of their funds, minus their management fee. This amount is not representative of the number that matters to us – the figure that ends up in our bank account after taxes and costs.
Professionals can trade frequently without generally considering the consequences on capital gains that are passed onto the end investor. This makes a significant difference to investors and influences the allocation of funds to particular structures. Investors must decide between multiple options – paying off a mortgage if relevant, putting funds into superannuation or investing outside of superannuation. Professional investors can invest without thinking of the most tax or cost-effective structure.
Concentration
One of the main ways that we’re exposed to professional investors is in financial news media. They often speak about stock picks in their funds, or why the asset class or sector they are positive on is going to blow the others out of the water.
These investments and the compelling narratives that go with them sound attractive. I attend a lot of investment conferences for work. Every time a ticker is mentioned, you hear the scribbling of pen on notepad. What is excluded from this narrative is how much this ‘bet’ makes up in their portfolio.
When looking at a ‘high conviction’ active ETF, the top holding doesn’t typically exceed 5% of the fund. A passive ETF that is tracking the ASX 200 has 17% in the top two holdings. Although this may not be a fair comparison, it is illustrative that the conviction that is conveyed may not be represented by action.
What you should take from professional investors
There are important lessons that individual investors can learn from professionals. One of the largest is setting proper frameworks for investment decisions.
Professional investors operate in a heavily regulated and structured environment that requires compliant funds and processes. This includes transparency in investment strategies and mandates so that investors understand the exposures they are taking on.
An Investment Policy Statement (IPS) is a tool professional investors use that can increase the success of an individual investor’s portfolio. It clarifies your thinking, prevents poor behaviour that is detrimental to your returns and guides decision making when maintaining your portfolio.
Professional investors have years of experience, teams of analysts and institutional grade data that inform their decisions. It is worthwhile listening to what they have to say. What is important is understanding the context in which they have viewed that opportunity and whether it is still an opportunity when viewed in your context. An IPS can help you easily determine this.
Final thoughts
Adapt what works. Do this by reconciling the academic or institutional insights with the practical constraints of a personal portfolio. It has different size, behavioural, time horizon and market realities.
Most of all, understand what you’re investing in and why. An Investment Policy Statement is a framework that works for professionals and for individual investors. If an opportunity from a professional investor fits into your investment strategy and your circumstances, it may be worthwhile pursuing.
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