A blog conversation between two investors caught my eye recently, reminding me of many a discussion I've had with friends who love investing.
It centred on the debate about whether small, part-time investors can ever be successful stock pickers - or should they leave it to professionals who manage lots of money and have an advantage?
One investor (let's call him Jim) described his mate Matt who manages a sizeable fund in New York. He spends "80-100 hours per week studying the market and has done so for over a decade. He reads annual reports, market news and studies every company announcement the moment it becomes available."
Matt attends annual shareholder meetings, talks directly to chief executives and meets regularly with other large investors. He is one of the "most well-informed people in his industry and is in the best position imaginable to predict the future success or failure of listed companies."
Interestingly, Matt aims to be correct just 60 per cent of the time. If he hits that target, he knows he will earn a decent bonus and his fund will attract more millions from clients.
Because of his efforts, experience and expertise, Matt has beaten the market by around 1-2 per cent per year throughout his career.
Jim ended by saying that "you'll have to get up pretty early in the morning to match Matt's performance; hardly anyone else has."
The other investor (Richard, an investor at the smaller end of the scale) said he'd back himself because he's smart and interested and he too spends every spare hour looking at the markets, reading voraciously, and visiting companies: "Here's the thing ... I am looking at stuff the Wall Street guys can't or won't look at and I can move quickly with my small investments - but it's harder for them to move big funds around".
Richard listed his successes during the year, boasting of the 25 per cent return on his $US5,000 investment which generated a welcome $US1,250 top-up to his wealth.
Jim congratulated Richard because he had beaten the market's return of 11.4 per cent by 13.6 per cent. Jim noted "that additional 13.6 per cent return - which really was extraordinary - is what Matt likes to call alpha. On your $US5,000 investment, your alpha of 13.6% equated to $US680."
"However, over 500 hours of research (10 hours times 50 weeks) went into that alpha last year. That's roughly $1.36 per hour. You would have been better off working a minimum wage job, saving money and building a passive income. Picking stocks was an utter waste of time from a profitability standpoint - and remember, even great investors struggle to get 1-2 per cent above market returns over the long run.
Jim concluded stock-picking, even for a prodigy, is a complete waste of energy for anyone with small funds to invest: "Chasing alpha in the stock market only makes sense if you have millions, or better yet, hundreds of millions of dollars to invest."
I've had this sort of conversation before and have met investors very much like Matt and Richard. They have each been successful, albeit at different ends of the wealth scale. In the past I have taken the view that alpha is alpha - if you can beat the market even with a small investment, you've done well.
But if you take account of the opportunity cost (is there a better use of your time and effort?) and the limited chance of consistent success (even the professionals struggle), maybe Jim makes a valid point.
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