What’s Your Edge? (3)

By Marc Majcher from Austin, TX, USA (IMG_4837) [CC BY-SA 2.0 (http://creativecommons.org/licenses/by-sa/2.0)], via Wikimedia Commons

Sleep per Day: (Target) 7h30m / day (Actual) 7h17m  / day (58 day average)

What’s Your Edge series – Part 1 Part 2 Part 3

In the previous article I talked about how a majority of institutional investors pursuing a Passive Investing philosophy in Market Cap Indexing meant that it was very hard to find bargains in the Large Cap space and that if one was to partake in Large Cap investing and beat the market, it would require lots of patience and inactivity.

But what if a retail investor like me doesn’t want to partake in Large Cap investing? The reasons are after all plentiful on why forgoing investing in the largest companies in the world makes sense for retail investors.

One of the biggest reasons why retail investors may not want to partake in Large Cap investing is the fact that most institutional investors (arguably where most of the best investors reside) invest in Large Caps not because they like to but because they are forced to.

In other words, Large Cap investing will never be the investment strategy that will yield the highest returns for a retail investor over the long run.

That’s because investment opportunities become much more limited to institutional investors as they manage large sums of money. In the words of Charlie Munger, “Buying those cheap, cigar-butt stocks [companies with limited potential growth selling at a fraction of what they would be worth in a takeover or liquidation] was a snare and a delusion, and it would never work with the kinds of sums of money we have. You can’t do it with billions of dollars or even many millions of dollars.”

What this means is, if you were to partake in Large Cap investing (with the lure of buying great companies and holding them forever as advised by Warren Buffett), you must realize that you’ll never generate the highest possible amount of returns available for the amount of capital a retail investor has to invest.

One of the most significant advantages for a retail investor is, after all, being structurally able to invest in opportunities with low institutional investor competition but with high potential upside.

Which leads to the second reason why retail investors want to forego Large Cap investing. The institutional investor competition is much much lower in certain areas. And the key to beating the market relies heavily on avoiding the “sharks at the table

So where are the areas where there’s very few sharks? Basically anywhere where there are risks that the sharks cannot compete in.

A majority of these risks can be found listed in Howard Marks’ memo called “Risk Revisited“, namely:

  • Possibility of permanent loss of capital
  • Risk of falling short
  • Fear of missing out
  • Credit risk
  • Illiquidity risk
  • Concentration risk
  • Leverage risk
  • Over-diversification risk
  • Volatility risk
  • Black swan risk (Basis risk / Model risk)
  • Career risk / Headline risk
  • Event risk
  • Fundamental risk
  • Valuation risk

The list of risks can be further refined into a few categories (may have missed a few) in terms of where retail investors can find areas with very few sharks:

  • Un-loved companies / industries due to poor macroeconomic conditions or temporary setbacks
  • Micro to small cap companies
  • Companies with very high volatility in stock price

I will talk about why these areas provide opportunities with very few sharks and how retail investors can aggressively use this situation to their advantage in the next article.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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