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Why Being A Copycat Investor Can Get You Hurt
While some investors are trailblazers and do their own research, many investors attempt to mimic the portfolios of well-known investors, such as Warren Buffett of Berkshire Hathaway, in the hope of being able to cash in on those investors world-class returns. But copying anotherinvestors portfolio, particularly an institutional investors portfolio, can actually be quite dangerous. So, before you jump on the copycat bandwagon, get to know the pitfalls of this approach to investing.
An Inability to Adequately Diversify Holdings
It is not uncommon for a major institutional investor, such as a mutual fund, to own more than 100 stocks in a given portfolio. Even Berkshire Hathaway (Warren Buffetts investment vehicle), which has a tendency to invest in fewer stocks as opposed to more, owns shares in some 38 (as of June 30, 2008) different public companies! (Read Build A Baby Berkshire and Warren Buffetts Best Buys to learn more about investing like Warren Buffett.)
Institutional investors like Warren Buffett are able to spread their risk over a number of companies so that if one particular company, sector, industry, or even country hits a rough patch, there are other investment holdings that may pick up the slack. Unfortunately, most individual investors have neither the funds, nor the financial wherewithal to ever achieve such diversification. (See what can happen when diversification goes too far in The Dangers Of Over-Diversification
So what do investors do when they realize that they cannot maintain as many positions as an institutional investor?
Usually, the individual investor will copy or mimic a small portion of the institutions holdings (that is, heavily invest in some holdings and ignore others entirely). Unfortunately, this is where trouble can occur – especially if one or more of those core holdings heads south.
An individual investors inability to adequately mimic an institutions diversification profile and mitigate risk is a major reason why many individuals fail to outperform major mutual funds - even if they maintain similar holdings. (To find out more about institutional sponsorship as a gauge of stock quality, read Institutional Investors And Fundamentals: Whats The Link?)
Different Investment Horizons
Many people like to refer to themselves as longer-term investors, but when it comes down to it, most investors want to see results in the first 12 to 24 months that they own a particular stock.
In fact, according to an often-cited November 2001 study by Gavin Quill (a senior vice president and director of research studies at Financial Research Corporation, a financial services research and consulting firm), mutual fund holding periodsin 2000 were only about three years! That is well shy of the more than 30 years that Berkshire Hathaway has owned shares of Washington Post Company. In other words, on average, institutions seem to have much more patience than their individual-investor counterparts do. (Read more about how investing for the long haul can benefit you in Long-Term Investing: Hot Or Not?)
In short, even if individual investors achieve diversification similar to the institutions they are looking to mimic, they might not be able afford or have the patience to sit on a given investment for five or 10 years, as they may need to tap into the funds to buy a home, to pay for school, to have children or to take care of an emergency situation, and doing so may adversely impact their investment performance .
