Retail Investor’s Edge – Can retail investors build an edge over professional investors?

What are the advantages of retail investors over money management firms and institutions?

Retail investors can build an edge over professional investors
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One would imagine that professional investors, with all their capital, large research teams and resources would have a considerable advantage of retail investors. In many ways this is the case, but retail investors actually have some advantages of their own. If you are an individual investor, the key is to understand when and where you do have an advantage – and when you don’t.

Advantages for professional investors

Professional Investors
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In this instance, we are using the term professional investors to describe various types of investors and traders who either work for a money management company or institution, or who control a substantial amount of capital. In other words, we are talking about market professionals with access to substantial resources. Some of the distinct advantages these professional investors may have over retail investors include:

  • Access to the best technology and information systems available.
  • Research teams with the time and skills to conduct in-depth fundamental analysis on a large number of companies.
  • Access to expensive research from external providers.
  • Access to proprietary data and unique alternative data sets.
  • The opportunity to communicate directly with the leadership of listed companies.
  • They pay lower commissions – although this advantage has narrowed considerably.
  • Professional investors often have access to flow – they can see large orders that retail investors don’t know about.

Exactly which of these advantages an investor will have access to will depend on the size and type of the company they work at. Everything is available at a price, so size matters.

Advantages for retail investors

Retail Investor
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Now we can have a look at some of the advantages retail investors enjoy. A lot of these are actually advantages because they are really disadvantages for large firms. Many retail investors aren’t even aware of some of the disadvantages large investment firms face.

Retail investors don’t have clients

Professional Trader / Client on Phone
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When you have clients, there are limitations to the way you can invest. Investment managers have to deal with inflows and outflows from their funds. When money comes in, they have to buy shares and when money goes out, they have to sell shares. Often, clients will withdraw money at the exact moment the fund manager would like to be buying, and commit new capital when the fund manager would like to be reducing exposure.

Client funds are managed according to a mandate which dictates the asset allocation mix, and how much capital can be invested in any sector or stock. Often, there are limitations on the annual turnover within a fund. This can limit a fund manager’s ability to take advantage of short-term opportunities and volatility. These are limitations that retail investors don’t face.

Quarterly performance is another issue that fund managers face. Professional investors are mostly measured on quarterly performance and their holdings are often assessed at the end of each quarter. This often causes fund managers to chase short-term performance at the expense of long-term returns. Individual investors have the luxury of being able to focus on the long term. 

Liquidity and flexibility

Flexibility with Buying & Selling
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Large funds have the advantage of more resources – but they have a disadvantage when it comes to flexibility. Buying and selling large quantities of a stock can take weeks, and in some cases months. The manager of a large fund will often miss out on opportunities that are only present for a day or two. Large funds also have a problem when it comes to investing in small cap stocks. For a large fund to own a meaningful position in a small company, they will have to buy a large percentage of the company. This creates even more liquidity problems for the fund manager.

An important part of investing is being able to recognize when you are wrong about a stock, cut your loss, and move on. Fund managers often have to explain their decisions to clients. That means they are often reluctant to sell a losing investment when they should – and they end up doing so when the loss is much larger.

It’s also a lot easier to be honest with yourself about mistakes when you don’t have any ego invested in a position. As an individual investor, you don’t have to tell anyone what stocks you own – which means your judgment isn’t clouded by trying to defend a bad decision.  

Fees and technology

Investors / Team
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In the past, there was a massive gap between professional and retail investors when it came to fees and trading systems. Nowadays the commission you pay on a retail brokerage account are negligible – and increasingly zero. Pro traders still have access to slightly better systems and investment tools, but the gap is very narrow.

The double-edged sword

Balance
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Many of the advantages retail investors have can be either a blessing or a curse. The majority of the advantages mentioned above, concern the flexibility that retail investors have. Flexibility can be a massive advantage if it’s used correctly. Used incorrectly, flexibility usually leads to overtrading or trading without a process.

There is something to be said for structure. Individual investors need to be disciplined to exploit their advantages in a structured way. And, at the same time, they should avoid situations when they don’t have an edge. One of the goals of any investor or trader should be to develop and define an edge that they can improve over time.

Developing your investing edge

Developing Investing Edge
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An edge is a process that you follow that you are confident will help you outperform a benchmark. For investors, your edge will come down to your skill at stock picking, and there are lots of different ways to achieve this. It makes sense to focus on your strengths as an individual investor and avoid trying to compete with professional investors if you don’t have an advantage.

A good example is value investing. If you don’t have a lot of experience with accounting and financial statements, you are going to find it difficult to value companies effectively. And, if you are working alone, you are going to struggle to analyse enough companies to find a meaningful number of investment ideas. So, before you adopt the value investment style, it’s worth asking yourself if you really have the time and skill to compete.

Market Timing
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Market timing is an example of an approach that can work both ways. Most investors are not very good at it and end up harming their performance when they try to time the market. However, a few investors are actually very good at market timing, and this gives them an edge. If you can prove to yourself that you can outperform an index by timing the market, it’s definitely a good strategy for you. But if you aren’t consistently good at timing the market, you should avoid it. In that case it makes sense to focus on long-term investing with a buy and hold strategy.

Very often, the best edge you can build as a retail investor will be to focus on an industry you already know well. If you have domain knowledge in an industry, you already know more than a lot of investors about those companies – and you should use this edge. Investment strategies that exploit volatility are another opportunity for retail investors to build an edge. This does require a lot of patience and discipline.

Developing your edge as trader

Developing Edge as Trader
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It’s easier for traders to measure and demonstrate an edge, because most trading strategies can be back tested, and the time horizon is shorter. A rules-based trading approach can be back tested with historical data on most technical analysis platforms. If your trading style is discretionary, you will have to use paper trading to test your strategy in real time. This will take a lot longer, but it’s worth doing as it will give you more confidence in your strategy and edge.

If you are a trader, the more unique your approach and trading style, the more robust your edge will be. Well known edges tend to disappear over time – so an edge that is uniquely yours is more likely to endure over time. To develop a unique edge, you need to do your own research to find patterns and anomalies. A stock screener is a good place to experiment and come up with ideas by combining different parameters. Some stock screeners, like the Finviz screener, allow you to back test filters. This should help you find strategies that have historically been profitable.

Developing a real investing edge takes time. If you are just starting out and learning how to start investing, your first goal should be to lose as little as possible. Risk management is key to making sure you don’t lose all your capital before you actually have a profitable edge.

Conclusion: Retail investors can build an edge over professional investors

As mentioned, one of the biggest advantages retail investors have, is the ability to be flexible. But you still need a process that you know works, and the discipline to stick to the process. The key to developing a winning edge is to get into the habit of testing ideas rather than just implementing them and hoping for the best. Anyone should be able to develop an edge with time and effort. And then it comes down to knowing and exploiting your edge – and avoiding situations where you don’t have an advantage.  

About Richard Bowman
Richard is partner at InvestOpen, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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