Wall Street and the financial media love to tell individual investors they have no chance in the stock market against big-money professionals using high-tech software to sift through complex stock trends. That’s true to an extent, but it’s only part of the story.
Sure, if individual investors want to play Wall Street’s game, they have little chance of winning. But individual investors don’t have to play by those rules to succeed, because they have some significant advantages of their own. Even better: Those advantages are almost impossible for pros to mimic, so they’re a long-term competitive edge for the little guy.
Individual investors have at least three edges over the pros.
You can focus on the long term
The value of patience is overlooked in a world of high-frequency trading, cheap commissions and one-hour Amazon delivery. But as Wall Street becomes more focused on the short term — the average holding period has shrunk from years to months — the rewards of patience go up.
Unlike individual investors, the pros must try to beat the market every day, every quarter, every year. If they don’t perform, their funds lose money and their jobs are at risk. So they often engage in short-term jockeying, chasing hot stocks that later cool, and trying to sell faster than all the other pros when the market weakens.
You can focus on the long term, however, buying and holding great companies and funds. Investors find the potential super returns by buying when others are selling cheap in periods of market fear, and by buying to hold. Returns like those on Amazon — which has chalked up a 49,000% gain since its 1997 IPO — happen only if you continue to hold.
Of course, an Amazon doesn’t come around very often, and they’re hard to spot before they run higher. But novices also can invest passively using exchange-traded funds and index funds, adding to their investment during times of weakness and continuing to hold. ETFs and index funds also provide diversification, making a safer portfolio than owning just a few stocks.
You don’t have a lot of money
No, really — not having a ton of money is a huge advantage here. Legendary investor Warren Buffett often laments in his annual letter to Berkshire Hathaway shareholders that if he only had less money he could generate higher returns. In fact, he’s famously said that he could earn 50% annual returns if he had less than a million dollars.
Buffett could buy small stocks that almost no one knows. While there’s no promise of 50% returns, this area of the market hasn’t been picked over by big investors, such as Buffett, who can buy only the largest, most-liquid stocks. Among the “small caps” — often defined as companies with a market capitalization less than $2 billion — lie the future great companies, hidden in plain sight. But their size makes them almost untouchable by Wall Street’s big money.
Even the funds and ETFs dedicated to small caps have a hard time and can hold only puny stakes in each individual company, because these funds need liquidity in their positions. So the funds’ exposure to any potential great company is quite small. That leaves opportunity for those able and willing to sift for bargains. But be aware that studies show it’s difficult to pick stocks that beat the broader indexes over the long term. It’s not a tactic to try with your whole retirement portfolio, or with any money you need in the short term.
You can remove emotion from the process
The stock market is the only market where the goods go on sale but people are too afraid to buy them. You’re going to be terrified to buy exactly when stocks offer the best future returns. But to profit, you have to zig when the market zags. You can’t do that if you’re too scared to act.
To take your emotions out of the decision, you can buy stocks or funds on a regular schedule, regardless of market swings. Set up a schedule to buy, or have your brokerage do it for you. Buy weekly, monthly or with every paycheck. If you’re funding a 401(k) plan with your employer, you’re buying regularly already.
The key point is to buy regularly even when the financial media screams that stocks are overvalued or that you’d be crazy to plunge in, like in 2009. After plummeting mercilessly for months, the S&P 500 index bottomed on March 9, 2009. By April 2011, the index had doubled — annual growth of 39%. Now six years further on, the index is approaching another double. From the 2009 bottom, the index is up more than 16% annually — well above the market’s long-run average annual returns of around 10%, or 7% after adjusting for inflation.
Buying all along the way, regular investors throughout the crisis didn’t time the bottom, so their returns aren’t quite as impressive as these bottom-to-top figures. Still, their performance destroyed the returns of fearful investors who scurried away during the height of the financial crisis and then waited for the market to become “safe” in 2011 or 2012, at which point it had already doubled.
Importantly, to get high returns you didn’t need to know which individual stocks to buy. The broadly diversified index fund did great, and such passive index investing is easier to do, too.
The first step? Get started buying stocks.
James F. Royal, Ph.D., is a staff writer at NerdWallet, a personal finance website. Email: [email protected] Twitter: @JimRoyalPhD