Secret Advantages for Small Investors

Picking stocks is not an exercise in futility. With patience and persistence, you can not only beat indexes like the S&P 500, you can also beat the pros on Wall Street. In fact, you -- the individual investor -- have an advantage over the slick professionals. As valuation luminary Aswath Damodaran told Fool co-founder Tom Gardner in an interview, "There are enough openings in the market that somebody who really understands what they're doing and knows their strengths and weaknesses can take advantage."

The individual investor's advantages
The biggest competitive advantage individual investors have is that we can afford to hold stocks for five years or more. Most Wall Street pros can't do that. As Damodaran said, "They have too many competitive pressures forcing them to be short term."

How does this help you? Master investor Ben Graham put it best when he said that in the short term the market is a voting machine; in the long term it is a weighing machine. In other words, the market becomes much more predictable as your time frame lengthens. By being able to hold great stocks without needing to gloss up performance for the sake of advertising, you reduce fees and taxes and let the market's historical lessons go to work for your portfolio.

Next, your personal portfolio has no constraints other than your own liquidity. Unlike many funds that set market cap, style, or country constraints, you can invest wherever you smell opportunity. It's OK to lose to the market for a few months (or even years) if you've set yourself up to profit handsomely for the next 10.

For evidence of your advantage, consider the plight of spinoffs in the market. A spinoff is when a large company creates a new, independent company from an existing division.

These large, widely held firms are spinning off smaller, lesser-known quantities, so prices of spinoffs tend to be depressed in the short term. They are sold by institutions that cannot hold the new shares because of market cap or other constraints -- and this creates opportunity.

Take, for example, UAP Holding (Nasdaq: UAPH), the agricultural chemical company that ConAgra (NYSE: CAG) spun off in 2004; or Medco Health Solutions (NYSE: MHS), the pharmacy benefit manager that was part of Merck (NYSE: MRK) until 2003; or Yum! Brands (NYSE: YUM), the fast-food giant that Pepsico (NYSE: PEP) emancipated in 1997. All three stocks dropped in the short term. Investors who bought soon after that earned 80%, 237%, and 326% returns, respectively.

The Foolish bottom line
Spinoffs are just one example of how enterprising individual investors have an advantage over Wall Street professionals. But, as Damodaran says, "This is a very tough game to win. It requires a lot of homework."