Stock Picking Works (But Probably Is Not for You)

Beyond Buy-and-Hold #16

The creation of index funds was a breakthrough for the middle-class investor. Most of us don?t have the time needed to do the research required to pick stocks effectively. Index funds provide us a means of obtaining the great returns available from stocks without having to go to all the fuss and bother associated with picking stocks.

That said index funds have often been oversold. Many indexing advocates argue that stock picking does not work and that everyone should thus be in index funds. Even Warren Buffett! They argue that Warren Buffett is just lucky! Oh, my!

Warren Buffett is not just lucky. Warren Buffett knows what he is doing and he obtains far higher returns than indexers as a result. It?s wrong for indexers to argue that indexing is the only way to go. And it?s entirely unnecessary from a marketing standpoint. Indexing is wonderful. Why not just say that and explain why it is so while being entirely straight up about it?

The arguments against stock picking

Those who try to convince us that stock picking doesn?t work make two arguments.

The first is a tautology. They point out that a broad index fund pays the average return for the market. There obviously are 50 percent of investors earning less than the average and 50 percent earning more than the average. There are costs associated with picking individual stocks. Thus, the group of investors picking stocks must collectively earn a lower return (after costs are factored in) than that earned collectively by the group of investors buying indexes.

This claim impresses many investors who don?t analyze it carefully. It shouldn?t. Like all tautologies, it proves nothing.

It is of course true that indexers as a class earn higher returns than stock pickers as a class after expenses are factored in. But no individual investor?s personal return is affected by the averages. The very argument put forward by the overzealous indexing proponents shows that nearly 50 percent of stock pickers earn returns greater than those enjoyed by indexers. So stock picking clearly has the potential to pay off for many.

The trick to making stock picking pay off is being sure to be in that top 50 percent. If you can pull that off, it?s worth doing. Can you?

You cannot do it without doing a lot of research. If, like most of us, you are not inclined to spend much of your free time learning about stocks, indexing is the way to go. So the advice of the overzealous indexing proponents is generally good. I just wish that they wouldn?t make their case in the way in which they often make it. It reflects poorly on indexing to have big-name proponents make the case for indexing by improperly putting down stock picking.

Who should try their hand at stock picking?

There?s an additional point that needs to be made here that adds further support to the conclusion (if not the methods) of the overzealous indexing proponents. Most investors are guilty of self-deception. If we took a poll asking all investors whether they are among the best investors out there, probably 70 percent would answer ?Yes.? If all those investors used their confidence in their skills as a justification for stock picking, a good number of them would end up with lower returns than they would have obtained by indexing.

Don?t pick stocks unless you are absolutely sure that you possess the skills needed to do so effectively. Most of us do not possess those skills. For us, indexing offers a ?Good Enough? return. Getting greedy will only hurt you in the long run.

The second argument made by the overzealous indexing proponents (sometimes as an add-on to the first argument, sometimes as a separate argument) is that even the professionals are not able to pick stock effectively. Reference is often made to studies showing that most mutual funds earn returns lower than the market return. If the people who make their living picking stocks do such a poor job of it, what chance does the average middle-class person have of getting it right?

I don?t buy it.

The real purpose of fund managers

The managers of mutual funds are not being paid to pick stocks effectively. They are being paid to attract investors to their funds. These are two very, very different tasks.

Someone who was trying to obtain the best possible long-term returns would have gone with a low stock allocation for the entire time-period from 1996 through 2008 (when prices were sky-high). But someone trying to attract money to a fund would have gone with a high stock allocation during this time (stocks were very popular during this time). Ignoring price is a winner from a marketing standpoint. It is the worst thing you can do if your goal is to invest effectively.

The managers of mutual funds have their hands tied. Pressures bear on them that make it impossible for them to make the best choices for investors in their funds. Individual stock pickers possess a huge edge over the professionals. The fact that most mutual fund managers perform poorly does not prove that stock picking does not work for informed individuals.

If you are sure that you possess the emotional balance and the willingness to work it required to be a successful stock picker, you should elect that option. But please don?t pass up the indexing option if you have any doubts whatsoever about your abilities. Indexers can obtain perfectly good returns without taking on the risks associated with placing a bet that they will not fall prey to the self-deception that causes many investors to think that they are better skilled than they are.

Stock picking works. But most of us don?t need to take on the work and risk that goes with this choice. Indexing is a boon for the average middle-class investor. Indexing provides us all a means of obtaining solid returns through a very simple and easy approach to investing.

Rob Bennett developed the first simple retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins. His bio is here.

( Photo by blatantnews )

8 Responses to Stock Picking Works (But Probably Is Not for You)

  1. Ok. The Lake Wobegone of Investing. Interesting.
    A company named Dalbar had some interesting data that showed a 20 year average (equity fund) investor return of 1.87% ending 12/31/08. Now, since the market CAGR was 8.43% over that same time, it would seem the average investor is doing far far worse than the market indexes. So worse that the simple indexer getting S&P-.1% will probably beat not half but 3/4 of all investors.
    I don’t have the time or patience to pick stocks for the bulk of our money. So I’m good for 1 or two stocks a year if that many. It’s not enough to call myself a stock picker, just enough to have a bit of fun. It’s ok that I bought Ford and GM. One is gone, the other up 8X.

  2. Thanks, Joe. Your citing of that study is most helpful.

    What you are saying both shocks me and makes sense to me (investing is weird that way — common sense itself is often shocking in this field).

    I find it believable that indexers would beat 75 percent of stock pickers because of the self-deception factor. And the particular stock pickers we are talking about in the study you cited are not people who picked individual stocks but people who picked equity funds. Those are probably the worst of the stock pickers because those who really like stock picking and really know what they are doing are likely picking individual stocks rather than letting fund managers do it for them. If you’re letting fund managers pick for you, that’s probably a sign that you should be indexing.

    Rob

  3. I think that it is ESSENTIAL to do stock picking. Index funds are for little old ladies and people who have absolutely no time to research the stocks they purchase and simply want to get a return equal to that of the market.

    Why go with an index fund when you can choose the best 2 or 3 stocks out of that fund? It makes no sense to accept the bottom of the barrel in the same group.

    My advice is always go best of breed and go with the flow…if a stock is rising, it is likely going to continue rising. If a stock is falling, then it is likely to continue falling.

    Lastly, why bother to get your investment slashed by the fees that come along with these funds…it is no fun.

  4. [i]Index funds are for little old ladies [/i]

    Thanks so much for sharing your thoughts, Primal Slant.

    The sad, pathetic thing here is that even most of the people you are calling “little old ladies” (indexers) think of me as a little old lady because I don’t even index when prices are high. Hey! I think little old ladies are going to be the next big thing. Little old ladies are cool!

    I’m just joking around. But I am truly grateful to you for adding some balance to the discussion.

    P.S.: I came within inches of buying Apple when it was selling at $15. If I ever get my hands on the little old lady within me that caused me not to pull the trigger on that one, I am going to shake her!

    Rob

  5. I don’t know if we want to get into the mechanics of stock picking here, but Primal Slant’s point–“Why go with an index fund when you can choose the best 2 or 3 stocks out of that fund?”–got me thinking about a strategy.

    Choose five high performing funds, and look for common stock holdings. Choose from stocks that appear on most or all of the portfolios of the funds. You’re tapping into the professional management of the funds without commiting money to them.

    The market has always been driven by “The Nifty Fifty” in vogue at any given time period, so rather than “buying the market” you’re targeting the cash magnets specifically.

    Any merit to this?

    Any risks?

  6. I think the strategy has merits. Anything is better than owning the entire fund in my opinion…especially with the scraped fees. But, many people don’t even have the time nowadays to even go that far in terms of research. I think fear holds most people back too, they figure, the fund is owned by so many other people – so they either feel that is a safety net or they have the comfortable feeling that if the ship sinks, they won’t be the only ones who drown.

  7. I feel like your strategy might be a well known tactic already in place, not to take away from the fact that it is a good idea.

  8. Corpfan1 – It’s amazing how fear drives so much, including the stock market. I’ve heard it said, in connection with stocks, that people would rather be wrong with the herd than right standing alone. It very much seems to be a widespread perception of safety in numbers, and most of us don’t have what ever it takes to break from the herd.

    JohnG – I was pretty sure it wasn’t new when I wrote it, but thought it was worth bringing up anyway. Thanks for weighing in with your thoughts.

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