The Dangers of Individual Stock Investing

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Some investors believe that the job of an investment professional is to analyze those individual stocks for the best return in the near future. Under this view, each year’s investing is like laying bets on a horse race. The financial advisor acts as a bookie with the power to lay bets for their customers. And you trust your advisor only to the extent that you believe your bookie has researched each horse’s bloodlines, who their trainer has been, what jockey is riding them, who they are competing against, what type of field they will be running on, and how fast they have been running in their practice races.

This view of advisors as stock pickers is a common misrepresentation made popular by commission-based stock brokers who only got paid when you moved money from one horse to the next. They needed to perpetrate the myth of their stock picking prowess in order to justify their entire profession. And while some stock pickers outperform the indexes, they are no more common than the distribution odds would suggest and they can’t continue their success any more than distributions odds would suggest. In other words, they were just lucky.

Every stock picker has narrative reasons why they believe that the stocks they select should do well. But for all of the stock pickers who are consistently right over some time period, there are an equal number of stock pickers who are just as consistently wrong. The statistics suggest that what is touted as individual stock picking prowess is nothing more than random luck. It further suggests that success in the future has little or even a negative correlation with success in the past.

Meanwhile, every study suggests that monkeys throwing darts will on average out-perform the cap-weighted return of the top 1,000 stocks in the U.S. market.

The reason is simple: On average, small cap stocks out perform large cap stocks.

The cap-weighted return of the U.S. markets is hampered by the fact that the 30 largest companies comprise about 40 percent of the market’s capitalization weight, but their return is about 1.9% lower than the remaining 970 companies. The monkey’s darts hit these smaller companies 97% of the time.

Periodically, I speak to individual investing organizations that are known to favor stock picking. They often spend a great deal of time and effort setting up stock screens, analyzing a company’s fundamentals, and looking at technical market movements. The mathematics and search techniques are both beautiful and daunting. When the method works, it is confirmation that stock picking is possible. And when the method does not work, the assumption is to blame the analyst and assume that more data and better analysis would have better anticipated what actually happened.

Individual stock picking requires being right twice, once when you buy and once when you sell.

My suggestion to stock pickers is that they might be able to boost their returns more with much less work simply by adding a low cost small cap value index fund such as the Vanguard Small-Cap Value ETF (VBR).

Factors like size have long-term investing statistics while individual stock picking has a narrative of the moment.

Most investors who focus on individual stock selection tend to choose U.S. large cap stocks. But this field of selection is just half an asset class. It ignores mid and small cap stocks. It also ignores foreign developed and emerging market companies. And it also ignores significant sectors that may reduce the volatility of the portfolio such as energy or real estate.

Another danger of individual stock picking is the volatility generated by individual stocks. Individual stock selection increases your standard deviation and therefore the risk of not meeting your financial goals. The wider scatter plot of potential returns causes some of those potential returns to fall below the minimum return necessary to meet your goals. It requires a large number of individual stocks before individual stock risk is diversified out of a portfolio.

An additional danger of a long-term individual stock selection strategy is that the lifetime return of many individual stocks is -100% as they ultimately go out of business. Long-term studies find that only 50.9% of stocks generated a positive return over 90-years. And just 3.8% produced a return greater than the value-weighted market. And just 1.2% beat the equal-weighted market.

Those are daunting statistics and worth taking the time to understand.

Although an individual stock strategy is extremely common among both investors and advisors, to beat common market indexes would require picking both the right stocks as well as regularly changing those in anticipation of market surprises. But by definition you can’t anticipate surprises.

The mathematical way of describing this phenomenon is to say that individual stock returns are positively-skewed, meaning that the mean or average return is much higher than the median or typical return. The best performing 4% of stocks accounted for the entire lifetime dollar wealth creation of the U.S. stock market since 1926. Without these 4% lottery winners in your portfolio, you may not get the returns you need to achieve your financial goals. Investing in market indexes help ensure that these lottery winners are in your portfolio and you will not miss out on the returns needed for long-term financial planning.

Yes, of course some random stock pickers will pick these lottery winners as part of their portfolio. They will look like geniuses. Others will pick the companies that go bankrupt and look like idiots. Statistics suggest that these are like the random penny that comes up heads or tails ten times in a row. These geniuses and idiots are no more prevalent than random stock selection would suggest.

Portfolio construction is extremely important to achieving your long-term goals. Don’t risk those goals by assuming that individual stock-picking is a superior strategy.

Photo by Mathew Schwartz on Unsplash

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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.