The Small Investor’s [Only] Advantage

– Dr. George Calhoun
Executive Director of the Hanlon Financial System Center

Dr. George Calhoun, professor of quantitative finance at Stevens Institute of Technology and the Executive Director of the Hanlon Financial Systems Center at Stevens, penned the below article. As a member of Research Advisory Board at Hanlon Investment Management, Dr. Calhoun works in conjunction with Hanlon on investment research. The Small Investor’s [Only] Advantage provides an analysis of the advantage small investors have over large institutional investors, a very thoughtful and compelling point of view.

Take a moment to study the second most interesting chart you’ll see this week. 1

Annualized Returns - Risk

This scattershot pattern shows the relationship over a four-year period between the annualized Return (the gain in value on an investment portfolio) and the level of Risk (the volatility or variability of that value over time) for 800 different computer-generated combinations of seven asset classes: U.S. Large-Company stocks, U.S. Small-Company stocks, European stocks, Japanese stocks, Pacific Rim stocks, precious metals stocks, and five-year Treasurys. These are simulations, but we can say with confidence that any real portfolio composed of these asset classes, for this time period, would lie somewhere within this field.

It seems a triumph of randomness. Classic Finance Theory holds that higher Returns are associated with higher Risk. But here the outcomes are spread out all over the Risk/Return space. Risk and Return are uncorrelated. One portfolio may have three times the Risk of another, for the same Return – or twice the Return for the same Risk.

A similar chart of the real-world performance of 82 large corporate pension funds shows that simulation and reality are not so different. 2

Average Return vs Average Plan Risk, 1977-1987

It is not only pension funds that struggle. Active Management in general has a dismal record. Only about a third of fund managers beat the market average in a given year. Only 10% or so can beat randomness two years in a row.3 Their efforts to construct superior portfolios seem no better than dart-throwing.

So – How can the ordinary investor ever hope to make money in the market? How can the amateur compete against the Professionals — the fittest survivors of the intense Darwinian environment we call “Wall Street” (to include Stamford CT, and Chicago, and London, and all the other hedge-fund rookeries)? The Pros have the experience, the technology, the capital, access to top quality research, and the best management talent money can hire. They work this game all day, every day. So if they still struggle against the random nature of the market, how can the ordinary investor ever hope to win?

But the pattern is not quite random. A hidden signal – of particular relevance precisely for the non-professional – lurks in noise.

For there is a hint of structure in the simulation results. The outcomes crowd slightly towards the “west/northwest.” Finance Theorists draw a line along this left edge, called the “Efficient Frontier” – where the best Risk/Return trade-offs are to be found.

The goal of Portfolio construction can be stated as follows: How can we move towards this Frontier?

The Efficient Frontier

Now – here is the most interesting chart you will see all week.

Annualized Returns - Standard Deviation

This is the same simulation but the time frame has been extended– from 4 years to 26 years. The structure clarifies. The Efficient Frontier is much more sharply defined. And all the portfolios have moved closer to the Frontier. The differences among them are greatly reduced. Not only that, but almost all of the portfolios show improved performance — lower Risk and higher Return.

26-Year Portfolios

It is extraordinary. Note also that almost all the 26-year portfolios outperform even the best 4-year portfolios. The gain from extending the investment time horizon is much more powerful, and more stable, than the traditional (and over-rated) benefit of conventional diversification.

This is the advantage — the only advantage, but a decisive one – that retail investors enjoy. It is an advantage that the Professionals cannot exploit. The Pros have trouble extending the investment horizon more than a couple years. They have their investors, with varying levels of patience, but few of whom are willing to wait decades for their pay-off. Fund managers have to report regularly, and a few bad periods can drive redemptions (investor withdrawals), management turnover, strategy shifts, and fund closures. They are forced to play the shorter game. And of course if they use leverage, or hedges with short positions – their ability to hang in for the long run is further compromised.

Time-averaging is the equalizer for Retail investors. Think of it this way: the Professionals must try to find the best outcome from among those in the Risk/Return space depicted in the short-term chart. The individual investor can be satisfied with an average outcome from among those in the long-term chart – and yet may still beat the best of the Pros. Instead of emulating them, small investors should simply commit, truly, to the Long Term perspective – and let the inherent structure of the market process do the rest.

1 William Bernstein, The Intelligent Asset Allocator (McGraw-Hill, 2001), p. 56
2 Gary P. Brinson, Brian Singer & Gilbert Beebower, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal, May/June 1991, pp. 40-48
3 Joe Light, “How to Find a Fund Manager Who Can Beat the Market,” The Wall Street Journal, January 12, 2013