Have you ever wondered why the great investors succeed where most fail? Having extensive financial knowledge helps, of course. But so too does recognizing how our financial system rewards certain types of behavior and penalizes others.
It is an oft-quoted statistic that the majority of mutual funds underperform the unmanaged S&P 500 index. The reality is a little more complicated than that, but suffice it to say that fees and taxes conspire to handicap mutual fund managers and drag down their performance. This is not surprising, since the average mutual fund turns over its entire portfolio once per year.
It gets even a little worse for the average consumer of mutual funds because they tend to move their money from fund to fund, chasing last year's big performer. But Princeton University professor Burton Malkiel's research shows that the top-performing funds from one year tend to underperform the market in subsequent years. So the moment the population notices the fund and floods money into it, the fund's performance falters.
They're not terrible investors
The problem with many funds is manifold, but it's concentrated on three elements: overtrading, expenses, and the institutional imperative. Fortunately, as individual investors, we can use the system to our advantage. By and large, mutual fund managers have to play a game, and we don't. In this case, not playing means winning. Unfortunately, most individual investors fail "not to play."
1. Don't overtrade. For all the howling that buy-and-hold investing is dead, I believe this is the method of investing that makes the most sense. This past week, someone told me he was disappointed in CryptoLogic's
Buying and holding NatusMedical
2. Avoid the institutional imperative. The awesome reality for individual shareholders is that there are no institutional imperatives. You're not going to get fired as manager of your own money just because you don't own Cisco
As an individual investor, you don't have to play that game. In fact, you shouldn't. Recognize that the talking heads on CNBC are trying to sell you stocks. Recognize that there are glamour companies -- like last year's Travelzoo
3. Fish where the fish are. As has been described many times, fund managers have certain limitations. Perhaps they have so much money to invest that shares in a promising $100 million company, like Utah Medical Products
The Foolish bottom line
But remember what I said at the beginning. It wasn't that we can crush mutual fund returns. It was this: Most fail. Most investors, unfortunately, don't know where to look for companies without counting on the hottest of the hot. Most investors don't know how to be patient, and they don't recognize that the market doesn't particularly care what they paid for a company, that things happen on their own time, and that great companies should be treated as great treasure. This is not to say that the few don't make their share of mistakes. Wow, believe me, they -- and we -- do. But disciplined investing almost cannot help increasing your odds at long-term success, and in this realm, the reward for success is pretty sweet indeed.
Bill Mann misplaced his funk in 1998 and has had to rent one ever since. He does not hold any of the companies mentioned in this article. CryptoLogic is a recommendation of the Hidden Gems newsletter. Bill would like to invite you to join Tom Gardner and him free for 30 days to explore some of the truly great opportunities in the realm of the small cap. The two newest picks were released today at 12 noon EST. Fool disclosure rules are here.
