Lesson 7 of 7
Where an individual is not behind
Four structural advantages an individual actually has, each with the disadvantage that sits beside it, and the index fund that remains the default answer.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The individual's real advantages are structural: size, mandate, redemption and horizon. None of them is about being cleverer.
- Each one comes with a disadvantage attached, and the disadvantages are larger for most people most of the time.
- The letter this academy cites most often says plainly that most investors should own a low-cost index fund.
This is the course's last lesson and its most easily abused. Read the right-hand column of every pair below as carefully as the left, because the honest summary is that the advantages are real and narrow and the disadvantages are real and wide.
Four advantages, and what sits beside each one
RowsDirectionColumnsWhat it concerns
The advantage, Capital and mandate
Size and mandate
The advantage, Time and attention
Redemption and horizon
The cost attached, Capital and mandate
No budget, no desk
The cost attached, Time and attention
No hours, no process
The four advantages, stated precisely
Size is the largest. A fund managing billions cannot take a meaningful position in a company worth 200 million dollars, and the research cost per dollar invested makes the attempt uneconomic. That entire part of the market is open to an individual and closed to most professional capital.
Mandate is second. An individual may hold cash for two years, hold eight companies, or hold nothing in a sector, and nobody terminates them for it.
Redemption is third, and it is the one the limits of arbitrage lesson explained: capital that cannot be withdrawn does not have to sell into a decline.
Horizon is fourth, and it only exists if the first three are used properly.
The disadvantages, stated just as precisely
The default answer, from the letter this academy cites most
Buffett's 1996 letter to shareholders puts it as plainly as it can be put: most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees, and those following that path are sure to beat the net results, after fees and expenses, delivered by the great majority of investment professionals.
The same letter is where the escape clause sits, and it is narrow. Should you choose to construct your own portfolio, what you need is the ability to evaluate selected businesses. He stresses the word selected: you do not have to be an expert on every company or even many, only able to evaluate companies within your circle of competence, and the size of that circle matters far less than knowing where its boundary is.
What would have to be true for you to be the one
The test this course ends on
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You are working in a part of the market where the constrained capital cannot go, or on a horizon it cannot use.
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You can say what you know from public documents that the price does not appear to reflect, and why the people with more money have not acted on it.
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Your capital is genuinely long-term, unlevered, and sized so that no decline forces a sale.
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Your return, after the hours you spend and the costs you pay, beats the index fund that requires none of it.
If you cannot answer all four, the default answer in the letter above is the better one, and saying so is not modesty. It is the same argument this course has been making about constraints, applied to yourself.
Check yourself
Which advantage is structural rather than a claim about skill?
- Being better at reading filings
- Small size, which opens companies that large funds cannot take a meaningful position in
- Having better judgement about management
Show the answer
Answer: B.
Size, mandate, redemption and horizon are facts about the capital. None of them requires the individual to be cleverer than anybody.What does the 1996 letter say most investors should do?
- Concentrate in a few companies
- Own common stocks through an index fund charging minimal fees
- Hold cash until prices fall
Show the answer
Answer: B.
It states that most investors, institutional and individual, will find that the best way to own common stocks is through a minimal-fee index fund.What does the same letter require of somebody who builds their own portfolio?
- Expertise in every company
- The ability to evaluate selected businesses within a circle of competence whose boundary they know
- A view on interest rates
Show the answer
Answer: B.
The emphasis is on selected, and on knowing where the circle ends rather than on how large it is.Sources
- Berkshire Hathaway shareholder letter, 1996: most investors, institutional and individual, are best served by an index fund charging minimal fees; and the circle of competence, where what matters is knowing the boundary rather than the size.
- Shleifer and Vishny, "The Limits of Arbitrage", Journal of Finance, 1997, for the redemption constraint on professional capital.
- Baker, Bradley and Wurgler, "Benchmarks as Limits to Arbitrage", Financial Analysts Journal, 2011, for the mandate constraint.
What this leaves out
- An advantage is not a return. Every item above describes a constraint other investors carry, not an outcome for anyone who avoids it.
- The disadvantages listed are not exhaustive and apply to most people most of the time.
- Nothing here says any reader should manage their own portfolio, and nothing here is advice about any security.