Don't Be Satisfied With the Pros

There’s a very good reason most mutual fund managers can’t beat the S&P 500. It’s the same reason most hedge fund managers can’t beat it, either.

Ironically, though, the reason they have such a hard time outperforming the overall stock market is the very reason you can get market-beating returns year in and year out…

This might come as a surprise. After all, the “pros” — the hedge and mutual fund managers that get paid with your money to manage your money — have tremendous resources. They went to elite business schools, they have Bloomberg terminals, and they go to exclusive investment summits with corporate CEOs, central bankers, and political leaders.

The pros can get all the latest and best research. And when they want to invest in a company, they can pick up the phone… and the CEO will answer. If they want to buy into an emerging country’s stock market, they’ll get a personal tour of that country’s primary industries.

You and I just don’t have that kind of clout.

But we also don’t have the same investment goals as the pros do. And that’s actually a very big deal.

There’s an old joke that illustrates the difference between us and them…

Two guys are out camping in the wilderness. It’s first thing in the morning when they step outside their tent and see a huge bear has wandered into their camp. One guy yells, “Holy $*^#!! There’s a bear, RUN!!” The other guy sits down and starts putting on his shoes.

The first guy can’t believe it. He stops and stares at his friend. “What are you doing? You can’t outrun that bear if he decides to come after us.”

As he finishes tying his shoes, the second guy says, “I don’t have to outrun the bear. I just have to outrun you.”

Professional money managers are the same way. All they care about is their own survival. They don’t care how fast they can run. Or how far.

In order to survive, all they have to do is beat the other guy by a percent or two. That’s it.

They don’t have to make their investors wealthy. They don’t even have to beat the market, so long as their peers aren’t beating it either.

Why Goals Matter

It’s like they are investing scared in a way. They are scared to take too much of a risk — to stray too far away from the herd — to make significantly better investment returns. So they diversify into sectors that are inversely correlated so that losses in one group will hopefully outweigh losses in another group.

They will always keep a certain amount of their available investment capital in Treasury bonds no matter what yields are. They may say they do this for safety or to have cash available to take advantage of unforeseen opportunities. But when you keep 10% to 30% of your capital in bonds that you know will underperform the S&P 500, what you’re really doing is undermining your performance.

Or maybe they will use position sizing to try to get a handle on risk. You put more money in stocks that appear safer and less in stocks that appear to have more risk. That way, if the risky stock tanks, it won’t tank the overall returns. But if you’ve done your due diligence and the stock launches, it may not help your overall performance much.

The pros are risk-averse. They don’t really want to be ahead of the crowd, to really stand out — they want to be right there in the middle of the pack with all the other professionals and maybe beat them by a percentage point or two. That way, they keep getting their fast bonuses, and the fact that none of them beat the S&P 500 ceases to become an issue.

But the thing is, managing risk is often an illusion. If the stock market tanks, all stocks are going down because in a severe correction, fundamentals don’t matter anymore. Avoiding losses and protecting cash becomes paramount, and that’s when selling begets more selling and you start to see those nasty 500-point drops on the Dow Industrials.

Any time you buy an asset, you are putting your money at risk because the price could fall, and then you can’t sell it for as much as you paid for it. That’s the plain truth. To pretend otherwise is just silly.

The Prevent Defense

In football, they call it the prevent defense. Once a team gets a decent lead, they change their tactics to try and minimize risk. The offense will run the ball more to try to use up the clock so the other team has fewer opportunities to score and also to avoid a costly interception that could lead to points for the other team.

On defense, the team might send more players into deep pass coverage to avoid a big play that might result in points for the other team. They might be happy to let the other team complete as many short five- or eight-yard passes, so long as they don’t give up a big 40-yard touchdown.

Every year, I see teams do this when they get a lead. And every year, I hear the announcer say, “Here’s the prevent defense, so named because it keeps you from winning.”

It doesn’t always happen. But enough teams have come back from deficits to beat teams that are using the prevent defense that it doesn’t get used as much as it once did. And the reason it doesn’t work is because it is a strategic change away from what was creating the success in the first place. All of a sudden, the team stops trying to win and instead tries to not lose.

This may not be a perfect description of how the professional money managers operate, but it’s not that far off the mark, either.

Another Way to Manage Risk

Pretty much any time I buy a stock (or recommend one to Wealth Advisory subscribers), I think that stock has a realistic chance to double in price in a year or two. If all I’m looking for is 15% gains, in line with the S&P 500, it’s just not worth the risk.

And it’s not like you have to buy “risky” stocks to double your money, either. Starbucks (NASDAQ: SBUX) is up 135% for Wealth Advisory subscribers in a little over two years. Boeing (NYSE: BA) is up 140% in about three years.

I don’t think any of us would consider these “risky” stocks. But I was absolutely thinking triple digits when I recommended them.

This is a huge advantage that the individual investor (you) has over the pros. You can concentrate your investments in quality stocks with a high probability of doing really well.

Can you imagine the reaction if a professional money manager said, “I put it all in Starbucks”? People would freak out, even though putting it all in Starbucks is really no more risky than buying a little McDonald’s, a little Wendy’s, and a little Dunkin Donuts…

In other words, nobody wants to lose 20% of their money. But a 20% loss is much easier to take after the stock has rallied 120%.

Until next time,

Until next time,

Briton Ryle

@BritonRyle on Twitter

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.