1 Unstoppable Advantage Retail Investors Have Over Institutions

What if I told you you have a super power that professional fund managers could only dream of? This special advantage not only gives you high odds of outperforming institutional investors, but also involves significantly less work and stress.

Sounds too good to be true? Well it's not.

But before I tell you what this power is, it's important to first understand how the “smart money” invests.

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How institutions approach the market

The term “institutional investor” refers to organizations or individuals that invest money on behalf of others. This includes mutual funds, hedge funds and pension funds to name a few examples.

One of the most interesting insights into the strategies of fund managers is how they are paid. While most managers have base salaries, the vast majority of their compensation comes in the form of a bonus based on the percentage of the fund's overall return. So in other words, money managers are directly incentivized to produce immediate returns.

In fact, it's not uncommon for professional portfolio managers to receive bonuses 5-6 times their base salary at the end of high performance years! So if a manager's base salary is $200K, they could make well over $1 million in total compensation if they perform well.

As if that wasn't enough incentive to focus on short term performance, funds that post sub par returns run the risk of investors pulling their money out and investing with competitor funds. A single year of negative returns could easily result in a portfolio manager being kicked to the curb.

Why is this important?

Institutional capital makes up $61 trillion of the total $103 trillion of the U.S. stock market – or 59%.

With retail investors still representing a minority of the market, understanding how the majority of the capital is oriented can provide insight into the short term movement of stocks.

In my early days of investing, I found myself constantly perplexed when a company would report stellar earnings but would proceed to sell off 15% or so due to something seemingly insignificant like conservative near-term guidance.

Nvidia's (NASDAQ: NVDA) recent earnings report is a perfect example of this scenario. The high-tech, graphics processing units (GPUs) company recorded quarterly revenue of $7.64 billion (a 53% increase) and earnings per share of $1.32, both of which exceeded analysts' expectations. Just about everything Nvidia reported was stellar, and yet the stock sank nearly 8% on the day of reporting, likely due to management's flat gross margin outlook for the next quarter.

The company's Executive Vice President and Chief Financial Officer, Colette Kress, even addressed the flat margin growth on the conference call explaining there is still a lot of room for improvement over the long term as they ramp up the software side of the business. But somehow this wasn't good enough for Wall Street, and investors proceeded to head for the exits.

But when you understand that the majority of the market is made up of short term focused institutions, this actually makes a lot of sense.

If my bonus was on the line (or worse I could get fired for underperformance), I definitely wouldn't want to own a company that painted any amount of uncertainty about the coming months, regardless of how promising the long term outlook is.

The advantage you have over fund managers

So what is the incredible advantage retail investors have over institutions? It's simply the luxury of taking a long-term approach to investing.

As long as you are not investing money that you need in the near term, there really are no consequences to underperforming for a quarter or two. You can sit back and largely ignore the near term volatility provided the long term thesis of your investments remain intact.

You also have a high probability of outperforming funds over the long term because institutions rarely enjoy the benefits of compounding interest due to their constant rotation in and out of stocks.

In fact, according to the American Enterprise Institute (AEI), from the period of 2004-2019, over 90% of large-cap fund managers underperformed the S&P 500, largely due to a lack of compounding.

The beauty of compounding

Compounding interest is the magic that can turn average Joes and Jills into millionaires. Consider a $10,000 investment that compounds at a 10% rate of return. After 30 years, that sum would balloon to over $170,000 without having to add an additional penny.

Now imagine if instead of a 10% return you combined that compounding with a disruptive company that grows exponentially over time. The return potential starts to get a bit nutty.

This phenomenon is not possible to achieve by constantly rotating in and out of stocks like many fund managers do. A 2019 study by Morningstar found that the average turnover ratio for domestic stock funds was 63%. In simpler terms, 63% of the average fund's holdings would be completely different from one year to the next.

Conclusion: don't play the institutional game

Statistics like the one above should make you realize you are not playing the same game as the institutions. While they are chasing short term performance in large part due to their compensation packages, retail investors should be seeking the generational wealth you can achieve by allowing great businesses to compound over extended periods of time.

While it can be tempting to join in the market's frequent rotation into new stocks, it's a losing game for retail investors… and not to mention a whole lot of work.

Outperformance with less work might sound like having your cake and eating it too, but if you keep your focus on the long-term prize, that's exactly what you might just do.

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