Savvy Investors Lead, Mediocre Investors Panic, Then Follow

In the past, my business partner and I have discussed the implication of periods in which our portfolio's total return trails the S&P500's. We have concluded that it is indicative of situations in which our portfolio selections are 'out in front' of the market, and other investors will eventually come around to our view, and, thus, drive up the value of our selections with their similar, albeit delayed, investment behaviors.

This month, we are seeing this in spades. Witness Goldman Sachs publicly mulling over a plunge into the sub-prime mortgage "meltdown," before the heat has even dissipated. Goldman is no slouch equity investor. It's even in our portfolio right now.

More than usual, I am confident in this view of the market, as described in the title of this post.

I have written before of mediocre investors and the normal curve. Some investors are positioned for future market and company equity returns, despite the views of many other, mediocre investors, to the contrary.

Equity markets are a unique place, in that each buyer or seller of a share has an equal impact, per share, with their action. However, some investors are much smarter, more effective, than others. And as with most normal distributions, there are more inept investors, by number, than there are superior investors. However, we don't know the exact distribution of equity assets among the variously superior, mediocre, or even inferior investors.

Over the long term, we would expect the superior investors to amass equity asset values at a greater rate than the the rest of the distribution of investors.

More to the point, while mediocre and inferior investors might outnumber the superior investors, the key is not just the broad market participation, but the particular equities in which each is invested.

For instance, over the past weeks, some investors have headed to the sidelines. My guess is these would be primarily mediocre and inferior investors. So, in this period, superior investors would perhaps be both different, in remaining invested, and, per Goldman Sach's potential moves, focused on specific sectors from which less-skilled investors are withdrawing.

The bottom line to all of this is that, when an investor is well-positioned to earn superior returns over the next several months, his positions may appear to be losing during periods of volatility over those months. Periods such as the past few weeks can easily contain more noise than signal, penalizing many who attempt to trade through such periods of upheaval.

The bulk of the assets in the equity markets are held by lesser-skilled investors. When they move due to shock, as in the case of the last few weeks, their buying and selling can distort longer-term values. In the moment, who is right? The fleeing crowd, whose selling depress prices, or the patient, unmoving few savvy investors, who are still invested when the market unexpectedly swings back to a positive direction?