Why being a copycat investor can hurt you

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 another investor's portfolio, particularly an institutional investor's 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 Buffett's 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!

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.

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 institution's 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 investor's inability to adequately mimic an institution's diversification profile and mitigate risk is a major reason why many individuals fail to outperform major mutual funds - even if they maintain similar holdings.Different investment horizonsMany 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 periods in 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.

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.

Institutional knowledge/research

In spite of regulations meant to level the playing field between individuals and institutions (such as Reg FD, which outlines a company's disclosure responsibilities), institutions often employ teams of seasoned industry analysts. These trained experts typically have many contacts throughout the supply chain and tend to have more frequent contact with a given company's management team than the average individual investor.Not surprisingly, this gives the institutional analysts a far better idea of what is going on at a company or within a given industry. In fact, it is almost impossible for the individual to ever gain the upper hand when it comes to such knowledge.This relative lack of knowledge about future earnings potential, opportunities for growth, competitive forces, etc. can adversely impact investment results. In fact, a lack of knowledge is another major reason why many individual investors tend to underperform mutual funds over time.
This is compounded by the fact that analysts can sit and wait for new information ,while the "average Joe" has to work and attend to other matters. This creates a lag time for individual investors, which can prevent them from getting in or out of investments at the best possible moment.

Keeping tabs on institutions is tough

Even if an individual has enough money to adequately diversify him- or herself, the willingness to hold positions for an extended period of time and the ability to accurately track and research multiple companies, it is difficult to copy the actions of most institutions.Why? Because, unlike Berkshire Hathaway, many mutual funds buy and sell stocks with great vigor throughout a given quarter. In fact, take T. Rowe Price as an example. According to the company's website, its Capital Opportunity Fund (which invests primarily in domestic securities) has a turnover rate of 63.5 as of July 31, 2008. That's big. This makes positions like these are hard to mimic because even if you had access to databases that track institutional holdings the information is usually updated on a quarterly basis.What happens in between? Frankly, those looking to mimic the institution's portfolio are left guessing, which is an extremely risky strategy, particularly in a volatile market.

Trading costs can be huge, and treatment may vary

By definition, institutions such as mutual funds have more money to invest than the average retail investor. Perhaps not surprisingly, the fact that these funds have so much money and conduct so many trades throughout the year causes retail brokers who service these accounts to fawn over them.Funds often receive favorable treatment. In fact, it's not uncommon for some funds to be charged a penny (or in some cases a fraction of a penny) per share to sell or purchase a large block of stock - whereas individual investors will typically pay 5-10 cents per share.In addition, even though there are rules to prevent this (and time and sales stamps that prove when certain trade tickets were entered), institutions often see their trades pushed ahead of those of retail investors. This allows them to realize more favorable entry and exit points.In short, the odds are that the individual, regardless of his or her wealth, will never be able to garner such preferential treatment. Therefore, even if the individual was able to match an institution in terms of holdings and diversification, the institution would probably spend fewer dollars on trades throughout the year, making its investment performance, on a net basis, better overall.
Bottom Line

While it may sound good in theory to attempt to mimic the investment style and profile of a successful institution, it is often much harder (if not impossible) to do so in practice. Institutional investors have resources and opportunities that the individual investor cannot hope to match. Retail investors may benefit more, in the long run, from an investment strategy more suited to their means.

-Glenn Curtis, Investopedia