It is well-known that investors usually underperform the return of the vehicles in which they invest. The reasons for this “investor gap” is that individuals are market timers due to, among other things, psychological biases such us overconfidence or herding behaviour. As an example, half of the investors in Fidelity Magellan during Peter Lynch’s management period lost money, although the fund obtained a 29% annualized (Source: IESE). Another example can be seen in the graph below, from Toward the sounds of chaos, by RBAdvisors, in which we can see that the average investor return is even lower than the 3-month T-Bill.
Thus, behavioural finance has become one of the most interesting and prolific research fields in economics and finance. Knowing our biases and the limits of our rationality is the only way to be more rational in decision-making. Nevertheless, knowing these psychological issues is not enough to achieve satisfactorily returns. It is essential to know how financial markets work.
Benjamin Graham showed us that the most important driver in performance is the price that the investor pays for an asset. Based on this axiom, we can prove how an individual investor can achieve larger returns than the investment vehicle in which he invests without doing financial engineering, just by taking advantage of market volatility. The secret for this is just buying more when the price decreases and sell some part of the position when the price increases. Or better said, increment the exposure when the margin of safety increases and reduce when it decreases. The essence of this strategy is that performance potential and net exposure should be positively correlated, which implies that an investor should be a contrarian, buying when the market is selling, and the opposite.
When prices of clothes and other daily goods or services decrease (for example in sales), people buy more of those products, while in the stock market, when people can buy future cash flows at a lower price, they reject buying. And the opposite occurs too: in the stock market, when the price of potential dividends increase, investors tend to buy even more, while nobody would do that in other goods and services market. By this strategy, an investor could invert the investor gap, outperforming underlying asset.
Turtle Creek investment strategy in Open Text Corporation
Source: Turtle Creek
In this example by Turtle Creek, we can see the evolution of the intrinsic value of Open Text Corporation, the share price and portfolio weighting. When the difference between share price and intrinsic value increases, the percentage of portfolio allocated in that asset increased and vice versa. This strategy allowed Turtle Creek to obtain a 70% annualized return on this security, while the asset itself has obtained ‘just’ a 9% CAGR.
If the strategy is well applied, when the stock price drops more than the share value, the position should increase while when price converges with value, the exposure should decrease. Rather than obtaining a lower return than the asset itself, and active investor with confidence in a particular stock can obtain extraordinary returns by implementing this investment approach.
In conclusion, an intelligent investor can outperform the stock in which he invests just by applying this simple strategy. Yet, it is not enough to be intelligent. The individual investor must be psychologically strong and have self-confidence when the stock market drops. Holding back the innate desire to sell when the price decreases is quite difficult, and maybe this is the key attribute that distinguish good and bad investors.