The Individual Investor’s Edge

October 28, 2014

by Patrick O’Shaughnessy

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Below is an excerpt from Patrick O’Shaughnessy’s new book, Millennial Money: How Young Investors Can Build a Fortune, which is available from the link above.

There is one final aspect of long-term thinking that is very important for young investors. Because we are bombarded with stories about how difficult it is to beat the market, you may feel as though you can’t beat the market or the professionals over the long term. When I first started in the business, it seemed like the pros had an enormous edge over small individual investors. Many professionals that I met had earned their masters degrees in things like financial mathematics, had PhDs in economics, had studied 1,000 hours to earn their chartered financial analyst (CFA) designation, and had studied under experienced portfolio managers. But I learned that professionals, despite all their training and resources, have one huge disadvantage – they are beholden to their bosses and their clients, and their jobs are on the line when they perform poorly in the short term. To minimize their “career risk,” professionals make decisions that sacrifice large potential long-term rewards in favor of more secure short-term returns, or at least returns that are similar to the overall market. I’ve focused on 20- to 50-year investment horizons in this book because that is what millennials should focus on. But in professional investing, three years is an eternity. If a professional manager is losing to the market for three years running, he will often be fired and replaced with another professional manager, usually one that has done well in the past three years.

Clients evaluate managers’ performance at least once a quarter and sometimes once a month. These short time periods are meaningless in the market, but have become the standard for measuring performance. We’ve had many clients hire us and then threaten to fire us less than one year later because we’ve underperformed. This concern about short-term performance has repercussions up and down the money management business. Money managers want to do well for their clients (which can be individuals, institutions, pension plans, endowments, or foundations), but they also want to keep their jobs. If they underperform the market, or as a pension manager they hire managers that underperform the market, there is a good chance that they will be fired. Making bold decisions introduces “career risk,” because it increases the chances that their decisions will get them canned.

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