For all of the attention lavished on managers of hedge funds and mutual funds, nothing beats being a small investor. Peter Lynch said as much in his classic One Up on Wall Street: Big institutions have the resources, but we have the potential for extraordinary returns.
Poor Warren Buffett?
For one thing, we can invest in any company we like. Warren Buffett would love to be able to say that. Instead, with so much to invest, he must focus on large-cap, super-liquid companies. It must be dreadful having so much money.
Even better, unlike huge institutional money managers, we don't need to perform every quarter. We don't need to jump on every fad or pretend to be "active" out of a fear of falling behind. We don't worry what our manager or client thinks of us. We can focus on buying the best companies at the cheapest prices.
Don't look this gift horse in the mouth
Digging up these rare values is what Philip Durell -- along with thousands of "small" value investors -- do every day at Motley Fool Inside Value. Sadly, too many individual investors do not fully exploit these advantages and never reach their true potential to trounce the market.
Trust me, you do not want to group yourself in with those underachievers. Fortunately, by simply avoiding these four common mistakes -- all of which I've made myself at some point -- you can dramatically increase your long-term returns.
Mistake No. 1: Trying to time the market
Each week, hundreds of stocks move up or down 10%. If you could just figure out which stocks will move which way, you'd be rich in no time. Some even seem to bounce between price levels, the way 3M
It's a great idea ... except that it doesn't work. Over the short term, price changes are essentially random. People are masters at spotting patterns, even in random data. Look at a chart long enough, and a winning strategy will appear -- only to evaporate when real money is at stake. Sometimes you win with such a strategy, and sometimes you lose. So it goes with random events.
When investing, 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 that the poor kitty will bonk his head, but the smart money says he'll land on his feet. So don't time the market. Focus on a proven strategy like value investing, where the expected return is significantly higher than average.
Mistake No. 2: Ignoring costs
Fees, trading costs, and taxes are the bane of the small investor. People manage your assets because they want their cut. This can take many forms: fund expenses, trading commissions, account management fees, and the spread between bid and ask prices on stocks. If there's any profit left, the government is quite eager to step in and take its slice.
Always be aware of the fees you'll be paying. Recognizing that higher costs mean lower returns, you should plan to minimize fees and taxes. Buy funds with low expenses. With your personal portfolio, avoid needlessly swapping Dow Chemical
Mistake No. 3: Buying the hype
Until this year, China's growth seemed unstoppable. With a rapidly growing middle class, the nation has developed an appetite for things associated with higher standards of living, such as Internet access. Similarly, when energy prices went sky-high, the need for alternative energy sources becomes even more pronounced.
But as many have figured out recently, that doesn't mean you can indiscriminately pick up a Chinese stock or just any alternative-energy stock. Even with recent declines, you'd still be way ahead if you'd tossed the dice early on China Life Insurance
Hype usually involves some truth, but it says little about whether something will be a good investment. When confronted with large demographic, political, or technological trends, never just assume that the trend will provide a sufficient tailwind to power your portfolio.
Instead, examine the company-specific factors. A tailwind is nice, but it's critical to understand the competitive advantages of companies in the space. Ask yourself why this company will be able to exploit the trend better than its competitors. Dell
Mistake No. 4: Betting on the market as a casino
The stock market can feel like Vegas. A gambler can go to a casino and get lucky tossing dice. An investor can, in complete ignorance, buy a stock, get lucky, and make money. You don't get turned away from either for lack of knowledge or even common sense -- only lack of cash. If you choose to gamble on the stock market for entertainment, you shouldn't be surprised, upset, or outraged if you lose money.
If, on the other hand, your goal is to make extraordinary profits, don't treat the stock market like a casino. Don't buy on hunches or speculations; buy because you understand the company and recognize that it's selling at a discount to its fair value. Always have a good grasp of (1) its fair value, (2) the company's strategy, and (3) the challenges it is likely to face going forward.
That's a process we at Inside Value follow every day. In our experience, this is the only way to buy stocks that offer a superior risk-reward trade-off.
By simply avoiding these four mistakes, you can dramatically improve your chances of success. Focus on value stocks with a suitable margin of safety, and look at the entire market. Then you can really exploit your advantage as a small and nimble investor. Peter Lynch (and Warren Buffett) would be proud.
If you're interested in finding dirt-cheap value stocks, you should chat with one of my favorite investors, Philip Durell. Philip is offering a free 30-day trial to his Motley Fool Inside Value investment service. There's no easier way to discover whether an advisor or a service is right for you. Simply click here to learn more.
This article was originally published on April 26, 2005. It has been updated.
Richard Gibbons owns no shares of any company mentioned in this article. 3M and Dell are Motley Fool Inside Value recommendations. Dow Chemical is an Income Investor pick. The Fool has a disclosure policy.