Why do the majority of retail investors struggle to match, let alone beat, market benchmarks? It's a troubling fact... despite access to numerous resources and tools, many individual investors see their portfolios consistently underperform. In this article, we focus solely on you, the self-directed investor. We'll explore common pitfalls in retail investing and provide actionable solutions to not only avoid these mistakes but also to thrive. Have you ever wondered what separates successful investors from the rest? Read on to find your edge.
The primary cause of this underperformance is often an excessive concentration of holdings in just a few companies, frequently fewer than five stocks in a portfolio. Drawing from my past experience as a co-owner of a brokerage, I've observed this common inclination among retail investors… it is driven by a powerful emotional bias: overconfidence. Investors tend to believe they have more control over their investments than they actually do, leading to an overestimation of their knowledge and their ability to influence outcomes in their favor.
Take a moment to evaluate your personal portfolio… if you discover that you hold only a few stocks, this message is aimed directly at you! The same rationale applies no matter what asset class you’re invested in. Crypto, for example, is a prime case where a new generation of investors is currently massively overconcentrating its capital… both in one asset class and, within that class, in only a few assets. This kind of overconcentration, where you double down on risk, can amplify losses just as much as gains.
It is worth noting that famous investors like Warren Buffett have famously advocated for concentrated portfolios. Buffett's advice to 'keep all your eggs in one basket… and then closely watch that basket' indeed supports the idea of concentration. However, Buffett also emphasizes the need for a sophisticated investment process that effectively manages risk. Every successful concentrated investor is, at their core, a skilled risk manager... otherwise, their success would be short-lived.
Entrepreneurs, too, often have substantial wealth tied up in their companies, which might seem to endorse the idea of concentration. However, the stories we hear are typically about those who have succeeded, while the many failures remain largely unnoticed. This phenomenon, known as survivorship bias, skews our perception of the true risks involved. Additionally, unlike typical investors, entrepreneurs possess control over and deep insights into their companies, allowing them to better manage the risks and return potential. This level of involvement and understanding is crucial in making concentrated investments work...
In this context, it becomes clear that investment concentration tends to occur at two extremes of the sophistication spectrum. Typically, only the most sophisticated investors, who have a deep understanding and ability to manage concentrated risks, or the least sophisticated, who may not fully appreciate these risks, tend to concentrate their portfolios.
Take a moment to consider which group you might align with…
Do you possess the deep market knowledge required to manage a concentrated portfolio effectively, or could your concentration be a potential oversight? Our subscribers not only learn to distinguish between these levels of sophistication but also gain the tools and insights necessary to improve their investment strategies.
So, for the vast majority of participants in financial markets, overconfidence and a lack of diversification act as potent performance inhibitors. The inebriating effects of this emotional bias often lead to overestimating one’s investing abilities and underestimating the risks involved. Consequently, the primary reason why self-directed investors underperform is their inadequate understanding of risk, coupled with their insufficient risk management skills.
Understanding and managing risk is not just about avoiding losses… it’s about strategically positioning oneself to meet financial goals.
At VMF Research, we firmly believe that becoming a better investor starts with prioritizing risk management over chasing potential returns. By diligently addressing risks first, returns will naturally follow. To truly understand risk, however, one must begin with the basics.
The concept of risk in financial markets is intrinsically linked to volatility, which is commonly measured by the standard deviation of returns. Although other measures exist, simplicity is often sufficient for foundational understanding. A larger standard deviation indicates a higher probability of outcomes deviating significantly from what is expected. According to a fundamental financial principle, higher risk, as reflected in volatility, should correspond to higher expected returns.
Understanding that risk is often synonymous with volatility is relatively straightforward and widely acknowledged. However, it's important to note that some investment philosophies, such as the Value School, define risk differently—equating it to the probability of suffering a permanent loss of capital, rather than to volatility per se. This topic, which we will explore more deeply in future articles, is further dissected behind our paywall, providing exclusive insights for our subscribers.
But, let's continue with the train of thought that equates risk to volatility. When you perceive risk as volatility, it is crucial to go a step further and understand the underlying drivers of this volatility—the true determinants of risk.
Various factors can lead to fluctuations in an asset's price… but, we can generally categorize them into two main drivers. The first concerns the asset's specific risk, which, in the case of stocks, relates solely to the individual company. Examples of specific risks include the loss of a key client, legal disputes, or the emergence of a disruptive new product or technology that could render the company’s value proposition obsolete.
The second driver of volatility is linked to market or macroeconomic risk, also referred to as systematic risk due to its pervasive impact on the entire economic system, affecting all companies to varying degrees. This type of risk is influenced by a range of factors, including severe financial crises, geopolitical events, fluctuations in interest rates and inflation, trends in economic growth, unemployment rates, and other macroeconomic variables.
It is important to note that the first driver of volatility, specific risk, can be mitigated by diversifying the number of assets in a portfolio. This is why it is often referred to as diversifiable risk. In contrast, the second risk driver, systematic risk, cannot be reduced through diversification alone. This is because, regardless of the number of securities held, each asset remains influenced by overall economic conditions. Hence, systematic risk is also known as undiversifiable risk.
You should also understand that finance theory posits that investors should expect to be compensated for bearing nondiversifiable risk but not for taking on diversifiable risk. This concept may initially seem confusing, but it becomes clearer as you enhance your skills and knowledge about Asset Allocation. This is the core value proposition of our Tier 1 publication, VMF's Strategic Asset Allocation.
These concepts may appear dense at the start, but rest assured, they are important!
These concepts may seem dense initially, but rest assured, they are crucial for successful investing. Understanding the statistical metrics that represent each type of volatility is essential. For example, an individual stock’s standard deviation is a clear indicator of the firm-specific risk mentioned earlier. Less familiar, perhaps, is the metric used to measure the macro and systematic components of portfolio risk—the correlation coefficient. Becoming acquainted with this concept is vital to comprehending how diversification effectively reduces risk.
The correlation coefficient measures the strength and direction of the linear relationship between two variables. In the context of a two-stock portfolio, this coefficient determines how these stocks move in relation to each other. It's important to note that there are also nonlinear relationships among variables, a topic we explore extensively in our publications. Returning to linear relationships, if the two stocks have a positive correlation, they tend to react similarly to events, such as positive economic news. Conversely, a negative correlation means they move in opposite directions in response to the same event.
Extending this analysis to the relationship between an individual stock and the entire market, such as a well-known stock index like the S&P 500, we introduce a closely related and popular concept: beta. This metric measures a stock’s volatility in comparison to the market index. Stocks with a beta above 1 are generally more volatile than the index, while those with lower betas are less volatile. High-beta stocks typically increase a portfolio’s overall volatility, whereas low-beta stocks tend to decrease it. But… more important than delving too deeply into these analytical concepts, is the recognition that as you deepen your understanding of risk, you'll discover the value of finding assets with low or even negative correlations among themselves. This understanding is crucial for constructing more efficient portfolios.
When analyzed through the lenses of these statistical risk metrics, and particularly when segregating the drivers of volatility into specific and systematic risks, it becomes clearer why retail investors underperform—they predominantly assume specific risk. Furthermore, even when they attempt diversification, it is often within the same sector, where stocks exhibit high correlations with each other, thus providing minimal diversification benefits. My earlier statement about the risks of a new generation of investors overconcentrating on crypto assets should now resonate louder...
So, it becomes obvious that to succeed as a concentrated investor, you need a significant edge over other market participants in analyzing specific risk. This advantage is not only required in the realm of investment analysis—such as an in-depth understanding of the fundamentals, technicals, and all other pillars from our Investment Process for each asset under scrutiny—but also in your decision-making process, especially in behavioral terms. Concentrated portfolios are inherently more volatile and, therefore, more prone to exacerbate cognitive and emotional biases. High concentration means increased volatility and, consequently, an emotional rollercoaster. That is why I emphasized at the beginning that consistently successful concentrated investors are not only exceptional risk managers but also proprietors of valuable behavioral competitive advantages.
In order to outperform, or at the very least, to mitigate the extent of underperformance, it's crucial to conduct an honest assessment of your competitive edge in the financial markets… both in analytical and, most importantly, in behavioral terms.
And that is precisely the purpose of VMF Research: to help you find your edge!
How do we achieve this?
By publishing independent, high-quality, evidence-based research that not only provides actionable investment recommendations but also enhances your Investment Process. Our goal is to augment your financial literacy, empowering you to become a better investor in your own right.
Our value proposition is structured around 3 Tiers, each capable of adding value independently, yet designed to synergistically compound on each other, aiding self-directed investors in crafting more sophisticated portfolios.
Tier 1 focuses on Asset Allocation, which is arguably the most critical decision in managing your investments due to its significant impact on expected returns. To assist you in this crucial endeavor, we have developed a thoughtfully constructed model portfolio that is strategically diversified across various asset classes. We predominantly utilize ETFs (exchange-traded funds) to craft our model portfolio, achieving optimal diversification and tapping into a multitude of investment opportunities. ETFs are chosen for their notable benefits, including liquidity, cost-effectiveness, and access to a continuously expanding universe of investment options.
Within the framework of the risk analysis introduced in this article, Tier 1 is strategically designed to effectively address and optimize the total systematic risk of your portfolio. It is essential to understand that an asset class encompasses a group of assets that share similar investment characteristics. The principal asset classes—namely equities, fixed income, and alternatives, which include real estate, commodities, private equity, and cryptocurrencies (recognized as an emerging asset class)—each possess their own unique systematic risks. These risks manifest in different responses to macroeconomic factors, geopolitical events, and shifts in market sentiment. By applying our proprietary Investment Process to these diverse asset classes, we develop a strategic asset allocation model that consciously tailors exposure to various systematic risks, assigning specific weightings to each asset class. Our ultimate goal in this Tier is to construct an efficient model portfolio that not only captures each asset class’s risk premium but also strives to maximize expected returns per unit of risk.
Tier 2 focuses on security selection. The goal is to identify individual investments within each asset class that meet the criteria of our proprietary Investment Process. In this tier, Model Portfolios are constructed around various rewarded risk factors—such as value, growth, quality, or momentum—themes designed to capture powerful secular trends, and even special situations like spin-offs. We place particular emphasis on these rewarded risk factors. Why? Historical evidence strongly supports that these factors have consistently been associated with market-beating returns. However, they do not outperform at all times. Rest assured, in our publications, we carefully monitor when conditions are most favorable for each of these factors.
Within the framework of the risk analysis introduced in this article, Tier 2 is designed to effectively address specific risk, giving you an edge in the analysis of individual security risks. This tier is inherently more active. While Tier 1 focuses on capturing each asset class’s risk premium, thus being rewarded for taking on systematic risk, Tier 2 targets the specific risks associated with individual securities. We publish carefully curated model portfolios organized by risk factors or themes, from which investors can select specific securities. However, if you have been paying attention, you will know to take care not to overconcentrate in only a few investments!
Tier 3 is designed to maximize alpha, focusing on outperforming the market and representing our most active product. In this tier, we select the most timely investments from the universe of recommendations available in Tiers 1 and 2. Additionally, Tier 3 introduces advanced risk management techniques that extend beyond diversification. These techniques include hedging through inverse ETFs or options overlays, which are negatively correlated with most assets and thereby potentially reduce systematic risk. We also emphasize proper position sizing and the implementation of stop losses. The objective here is to achieve absolute returns, consistently striving for positive outcomes regardless of the market environment. Subscribers will find in-depth technical explanations of trade setups, providing insights into the rationale behind each recommendation. Each position is accompanied by comprehensive trading plans, offering detailed guidance on entry and exit strategies, risk management, and potential profit targets.
Pablo Picasso is attributed with saying, 'Learn the rules like a pro, so you can break them like an artist.' Our three tiers are designed to complement each other perfectly. While Tiers 1 and 2 diligently follow the rules like a pro, Tier 3 adopts a more active and aggressive stance, attempting to methodically break them like an artist.
Give us a try!
Let us help you find your edge.