Small investors are in a great position compared with everyone else in the stock market. We don't have the resources of institutional investors, but we have so much more potential to earn extraordinary returns. We can invest a reasonable part of our portfolio in almost any size of company, so there's always something cheap. Warren Buffett doesn't have the same advantage. BerkshireHathaway (NYSE:BRKa) (NYSE:BRKb) holds billions of dollars in cash because Buffett can't find any large companies that are cheap enough to purchase. It must be dreadful having so much money.
Unlike institutional investors, small investors don't have the pressure to perform every quarter. We don't have to jump into every investing fad, or pretend to be an active investor (but actually just try to match an index) out of fear of underperforming. We don't need to think about politics. Instead of worrying about what our manager or clients will think of our purchases, we can focus on buying the best companies at the cheapest prices.
Despite these advantages, many small investors do not fully exploit their potential to trounce the market. By avoiding four common mistakes -- all of which I've made at some point -- investors can dramatically increase their returns.
1. Timing the market
Over the course of a week, many stocks move by 10%. If you could just figure out which stock will move in any given week, you'll be rich in no time. Or, there are some stocks that seem to move between price levels, such as the way Microsoft (NASDAQ:MSFT) has bounced between $25 and $30 over the past two years. If you could just buy the stock once a month at the lower price and sell it a few weeks later at the higher price, you'd have a profit machine!
It's a great idea, except that it doesn't work. Over the short term, stock price changes are essentially random. People are really good at seeing patterns, even in random data, so if you look at a chart long enough, it may seem as though a winning strategy exists. However, winning patterns tend to evaporate when actual money is at stake. You'll win sometimes with such a strategy. And you'll lose sometimes. This is the norm when you bet on random events.
Your results will be similar to gambling on a coin toss. You might have some great winning streaks, but in the long term, you'll likely have average performance. As an investor, however, you want your results to be less like the flip of a coin and more like the flip of a cat. There's some chance of the poor kitty bonking his head, but the smart money says that he'll on his feet. So don't focus on market timing, but rather on a strategy like value investing, where the expected return is significantly higher than average.
2. Ignoring costs
Fees, friction, and taxes are the bane of the small investor. People manage money for others not just because they're altruistic and wish to help everyone achieve their financial goals, but also because they want a cut of the wealth. This cut can come in many ways: mutual fund expenses, trading commissions, account management fees, and in the spread between bid and ask prices on stocks. If, after all these fees, there's a profit left, the government is quite eager to step in and take its share.
Since such people are unlikely to show restraint with your money, it's up to you to ensure that they act responsibly. It's impossible to invest without fees and taxes, but before going into any investment, you should be aware of the fees you'll be paying. Recognizing that higher fees often mean lower returns, you should then plan your investment strategy to minimize fees and taxes. If you invest in mutual funds, buy only those with low expenses. If you're focused on stocks, avoid frequent trading that will result in higher taxes and commissions that eat into your returns.
3. Focusing on the hype
China is growing at an amazing pace and presents incredible investment opportunities. The untapped market of satellite radio is the next big mass communications medium, and one of the two players, Sirius Satellite Radio (NASDAQ:SIRI), is signing some big names. The iPod is incredibly popular, and Apple (NASDAQ:AAPL) continues to be one of the most innovative companies in the world. The Internet revolution will seem like a minor blip compared with what's going to happen with nanotechnology.
I think there's a good chance that all those things are true. But just because they're true doesn't mean you can simply buy any company with "China" in its name and expect to make a fortune. The Internet revolution was huge, and Yahoo! (NASDAQ:YHOO) continues to be one of the most successful Internet companies. Yet investors who bought at the highs lost 90% of their investment within two years, and even with its rebound they are still down 65%.
Hype usually involves some truth, but it's insufficient for determining whether something is going to be a good investment. If a company has a 10% chance of returning 800% within a year but a 90% chance of falling to nothing, it isn't a good investment -- its expected return is negative. If you frequently make investments like this, you'll lose money over the long term. So, when confronted with large demographic, political, or technological trends, it's important to not just assume that the trend will provide a sufficient tailwind to power your portfolio.
Instead, take a step beyond the trends that the mass media focuses on and examine the company-specific factors. A tailwind is nice, but it's critical to understand the competitive advantages of companies in the space. In other words, ask yourself why this company will be able to exploit the trend (and generate profits for shareholders) better than its 50 competitors. Because of its competitive position over the past 10 years, eBay (NASDAQ:EBAY) has flourished while hundreds of imitators have collapsed. Without that competitive position, eBay would have been just another dot-bomb.
4. Treating the market as a casino
The stock market can be quite similar to a casino. In both, it's possible to make or lose money quickly. A gambler can go to Harrah's and get lucky tossing dice. Similarly, an investor can, in complete ignorance, buy a stock, get lucky, and make money. You don't get turned away from either venue for lack of knowledge or even common sense. Only for lack of cash.
Unlike many Fools, I think it's perfectly reasonable for people to gamble on the stock market for entertainment, just as I think it's perfectly reasonable for people to gamble at casinos for entertainment. But I think gamblers in either case should not be surprised, upset, or outraged if they lose money.
However, if the goal is to make extraordinary profits and not just be entertained, then it's a mistake to treat the stock market like a casino. There are reliable ways to make money in the stock market. Stocks should not be purchased based on hunches or speculations, but rather because you understand the company and recognize that it's selling at a discount to its fair value. As an investor, before you buy a stock, you should have a good understanding of the fair value of the stock, the company's strategy, and the challenges that it is likely to face going forward.
At Motley Fool Inside Value, we believe that purchasing well-run companies at a discount is the way to achieve incredible long-term results. That's why when we make a recommendation, we always discuss the business and its recent history, competition, valuation, and risks. By fully understanding these factors, we're able to select the stocks that offer a superior risk-reward trade-off.
Conclusion
Avoiding these mistakes and focusing on value will help to ensure that small investors can exploit their advantages to achieve outstanding returns. If you're interested in what we see as the dirt-cheap values available in the market today, Inside Value is offering a free 30-day trial. Or, for a limited time, you can purchase a subscription to Inside Value at a 25% discount to the regular price.
Richard Gibbons, a member of the Inside Value team, does not own a cat or any of the stocks discussed in this article. He tosses cats only infrequently, so no felines were injured during the writing of this article. The Motley Fool has a disclosure policy.
