Individual Investors Unite!

The Fool's mission is to "Educate, Amuse, and Enrich." One way we try to do that is to help individuals -- armed with knowledge and willing to do some hard work -- beat the market.

In my final session with Michael Mauboussin, chief investment strategist at Legg Mason and author of the new book More Than You Know, Michael summarizes some advantages that individual investors have over institutions and offers his top three areas of focus to maintain that edge.

David Meier: What are some areas where individual investors might have an advantage over an institutional investor?

Michael Mauboussin: Well, I think that many institutions, especially if they are sizable ones, face a lot of market impact costs. In other words, when they buy or sell securities, they tend to affect the prices of those securities, whereas that is not true for individuals. So, often, a large investor simply cannot participate in, for example, smaller or less liquid stocks simply because there is not enough liquidity. So that would be one area, I think, [in which] small investors could do very well.

The second thing is that large investors often feel incentive-cause biases, which lead them to be more short-term oriented. Hence, they tend go with the pack rather than being a contrarian. I think if you are a very disciplined individual and you recognize some of these things, it allows you to try to go against the pack and do that relatively cost-effectively. But I would just say for most people, it is very difficult to do.

Often, I would say that participation in the stock market over the long haul clearly makes sense. But for many, many people, unless they have a lot of interest in [the stock market], indexing makes a lot of sense. It's a low-cost way to participate.

David Meier: What are three things that individual investors, without having the benefit of a good, smart, well-paid research staff like Legg Mason's, can take away from your book to improve their results? The top three things.

Michael Mauboussin: (Laughs.)

David Meier: I had to put you on the spot.

Michael Mauboussin: Yeah, I am thinking. The first thing, I would say, is to focus on process versus outcome. So process means understanding the research process, trying to understand specifically if expectations in the prevailing stock are too high or too low, and recognizing that even if you have a good process, periodically things will not turn out as you had hoped. [However,] a good-quality process will lead to good long-term results.

The second thing I would say is, recognize the role of time. In the very short term, it is almost impossible to discern between luck and skill, because there is just simply too much noise in the system. But over the long haul, certainly a good process will prevail. So [recognize] that it is important to be patient, and often, as you said before, to do absolutely nothing. This is not a business where more activity leads to better results. I think, in general, people perceive that. And certainly in America, there is an idea that doing more work is better. That simply does not hold for the stock market.

The third thing is to recognize that markets are fundamentally probabilistic, and because they are probabilistic, it requires a certain psychological approach and psychological mindset. By the way, in Robert Rubin's wonderful book, In an Uncertain World, he talks a lot about the probabilistic mindset. He says many people believe they are [taking such an approach,] but very few people have the disposition or time or training to do it properly. So when you have a probabilistic mindset, you are constantly thinking about different alternatives. You are constantly taking information and updating your probabilities and outcome assessments and recognizing, again, that there are many psychological biases that can come into your doing that properly.

So -- process versus outcome, understanding the role of time, and recognizing the probabilistic nature of the market would be the three top for me.

Sneaking in under the radar
Being able to sneak in under the market's radar is such a nice advantage for the individual investor. Our portfolio sizes are usually small enough that we don't have to worry about "moving the market" when we buy or sell.

Contrast that with a huge mutual fund like Fidelity Magellan. With almost $50 billion in capital to invest, the fund is limited to taking decent-sized positions in the largest companies. No wonder its top five positions have market caps in excess of $33 billion.

By focusing mainly on large companies, Magellan usually misses the opportunities that smaller companies present. Although Daktronics (NASDAQ:DAKT) and Christopher & Banks (NYSE:CBK) have been two of the top-performing stocks over the past 10 years, they probably haven't been anywhere near Magellan's radar screen. And even if they were, they were far too small to have a significant outcome on the fund's returns.

Sometimes it's good to be a small fish in a big pond. But don't forget, the market is not for people who aren't willing to invest time in research. An index fund is a great alternative if you don't have the sweat equity to invest.

The Foolish final word
Our goal at The Motley Fool is to help you become a better investor by educating you with great content (like my interview with Michael), amusing you along the way, and enriching you should you become a subscriber to one of our market-beating newsletters.

I would like to thank Michael for taking the time to talk with me and sharing the incredible wisdom he's gathered over the years and put down in his new book, More Than You Know. I've read it twice and would highly recommend you do the same. If you remember your advantage as an individual investor and practice the three things Michael talked about above, I guarantee that you'll be a better investor.

This article was originally published on July 14, 2006.

Legg Mason is an Inside Value selection. Daktronics is a former Stock Advisor recommendation. Johnson & Johnson is an Income Investor pick.

Retail editor and Inside Value team member David Meier does not own shares in any of the companies mentioned. He is currently ranked 437 out of 19,864 investors in The Motley Fool's CAPS stock-rating service. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.