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What retail investors can learn from the smart money

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Recent headlines make scary reading for retail investors – "Why a 20-per-cent correction is coming;" "Market selloff;" "Are you prepared for the inevitable stock market correction?" How should we react to these warnings? Re-evaluate our portfolios? Sell? Buy?

What if I told you there was a class of investors that consistently outperforms retail investors, with a relatively straightforward investment strategy? And perhaps most important, that this class of investors factors in headlines like these into its strategy so that it typically does not pay too much attention?

Pension funds and other institutional investors, or as I like to call them, the "smart money," have a lot to teach retail investors. First, they have clear goals in mind. Typically, they have a pool of money (a pension fund), that has regular inflows (new contributions) and regular outflows (payments to pensioners). The goal is to manage the money so the fund can make a target return that will allow it to make the necessary payments periodically, no matter what the market conditions are.

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Retail investors can apply the same principle to their own investments. When saving for retirement, for example, retail investors can reasonably determine the pool of money (their retirement savings), their regular inflows (new contributions) and the regular outflows (their annual lifestyle spending during retirement).

With the goal clearly stated, the smart money then creates a plan to help maximize the likelihood of achieving that goal. The first step is to determine where to invest the money (the asset allocation targets): how much to put toward Canadian equities, Canadian fixed income, U.S. equities, emerging market equities, etc. Each asset class has differing risk and return expectations and the smart money realizes the best way of managing risk is to have a properly diversified portfolio. The next step is to find investment managers (in-house or third-party) to manage each asset class. Typically, the managers have long-term track records and a consistent and repeatable investment process.

Similarly, once retail investors know their goal(s), they can also put a plan in place – asset allocation is as critical to their financial well-being as it is for the smart money. Retail investors can also choose managers (ETFs, mutual funds or portfolio managers) to implement each asset class in their allocation.

But the real edge the smart money has over the retail investor is their ability to control their emotions (both greed and fear) in their investing activities. Retail investors have often blamed their poor returns on their investment managers. But, in many cases, they should be looking in the mirror.

A recent article by Morningstar titled "Mind the Gap 2014" looks at the actual return that fund investors enjoyed as opposed to the published returns of the funds. The key difference between the two measures is that the first takes the fund's returns and adjusts for inflows (when an investor wants to invest more in a fund on a hot streak) and outflows (when an investor bails on a fund with weak recent performance). Morningstar's data showed that over the last 10 years, actual investor returns underperformed the underlying equity fund returns by between 1.7 and 3 per cent annually, depending on the equity category, even after taking management fees into account. Morningstar's take is that "people actually tend to select good funds. But their timing in moving among asset classes tends to stink."

The academic research bears this out. In a recent comprehensive study of British investors, researchers concluded that this performance gap averages 1.2 per cent annually for retail investors for the period between 1992 and 2009. In contrast, the researchers found virtually no performance gap (about 0.3 per cent annually) for institutional investors.

Now, one might think that the retail investor data are skewed by lots of unsophisticated investors. But a 2011 paper found that investors in hedge funds, who typically have to be accredited investors and demonstrate higher net worth, had similar performance gaps averaging 4 per cent annually, rising up to 9 per cent per annum for "star funds."

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What is the takeaway for the retail investor? Controlling your emotions is critical to investment success. Those who have the time, skill, desire and discipline to put a plan in place and stick to it can certainly choose to do so on their own. Those who do not, however, should seriously consider seeking advice from a trusted professional investment adviser.

Sam Sivarajan is head of investments for Manulife Financial's private wealth business.

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