Commas and Zeroes (part 2)

By Brad Thomason, CPA

 

In a recent post I spent a few minutes skewering the idea that the only difference between large financial transactions and small ones was the number of commas and zeroes.  Today I’d like to make a loose continuation on that theme and look at a couple of differences between the way Main Street invests and the way Wall Street invests.  There are qualitative differences between large accounts and small accounts: the differences go beyond the number of commas and zeroes each contains.

Today’s post is symmetrical, I guess you could say, in that there’s one way in which Main Street has a big advantage over Wall Street; but in another way, Main Street would gain from acting more like their larger investing cousins.

First, the advantage.  If an entity holds a large investment in a certain stock, to some extent they are stuck with it, for good or bad.  They might be able to sell a portion of it if they expect a downturn, but if they sell in too high a volume it will be noticeable enough in the marketplace that it will actually become the cause of the very decline they are hoping to avoid.  The big boys know that if they all run for the exits when things start looking shaky, not all of them will make it and the ones left holding on will see their remaining holdings driven to even lower values as the heavy selling sentiment feeds back on itself.  This constraint is simply a fact of life for a large portfolio (like a mutual fund or an endowment), and it’s something they all just have to live with.

But it’s not something you have to live with.  You can get out of the market without moving the market.  If the price wants to flip over and head for the dirt, you have the luxury of getting out of the way and watching from the sidelines.  That’s a huge advantage that the individual has over the institutional investor, and it is a difference which should be reflected in the individual’s game plan.  Failing to play to that very valuable strength has been shown long-term to be costly for individuals.  Just because the big boys are stuck with buy and hold, don’t make the mistake of thinking that you are too.  Because you aren’t.

On the flip side though, there is a behavior common to large portfolio managers that the small investor would probably do well to pay attention to and try to emulate.   Many individuals enter positions in a way that almost seems to imply that they are saying, “Well, let’s give this a try and see if it works.”  That is to say, they assume that the position is going to go in the direction they think it will, and don’t take any additional steps to protect themselves if things do not go according to plan.

Measures to protect against the down side can be as simple as a stop-loss, or as complex as a multi-legged derivative position with lots of moving parts.  But as a general statement, the pros use these measures much more often than the typical individual investor.  Why?  Well, in some instances it goes back to what we were talking about earlier.  Since they can’t sell out of the position if the market moves against them, they deploy other strategies to attempt to offset part of the negative move with gains elsewhere.

I’m not advocating that people over-complicate their investing, and it should be pointed out that deployment of neutral-position hedges and derivative transactions is not something for the uneducated.  But this is not an all or nothing situation: even if constructing offsetting positions is a bit much, setting a stop loss, or deciding ahead of time that you are going to sell at a target or in response to a stated price decline, is something that’s relatively easy to implement.

So, one and one.  You are not stuck in a falling market like the big boys:  take advantage of your ability to move your money without moving the market.  But, don’t lose sight of the fact that the big boys can teach you a thing or two about controlling risk.  Because if the folks who invest for a living take time to think about the possibility that they might be wrong when they go into a position, what grounds does the hopeful amateur have for not being similarly cautious?

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