Making the Case Against Stock Picking
There’s no lack of coverage for investors who like to take their investment portfolio into their own hands. Carefully picking individual stocks and designing a custom, self-built portfolio gives investors a great sense of accomplishment and satisfaction. But unless you know what you’re doing, your portfolio may end up doing more harm than good.
Diversification is touted as the number one rule when it comes to investing and portfolio design is no exception. But diversification can be harder to attain than investors sometimes think. For example, an investor might add Caterpillar to their portfolio without realizing that it does a lot of business overseas, making it subject to foreign exchange risks.
Many investors are beginning to doubt the traditional buy-and-hold model of stock selection in favor of simply buying an index investment and riding up the volatility. In the past 90 years, the S&P 500 has registered a return of 9.8 percent, while most investor’s struggle to maintain a return of more than 8 percent. The case against stock picking is getting stronger.
The dangers of great investors
Many investors idolize certain other investors who have historically outperformed the stock market, like Warren Buffet, Ray Dalio and others. But there’s a problem in the logic that “because they did it, so can I.” Like anything with a large enough sample size, there will inevitably be outliers – those who under-perform relative to the market, and those who outperform compared to the market.
Just because there’s a fund manager who has consistently beat the S&P 500 by 10 percent or more over the past decade, doesn’t necessarily mean they have a secret investment formula. In fact, odds are there will be at least one fund manager who has consistently higher-than-average returns.
This skewed logic means everyday investors believe they too can beat the markets by investing like other great names in the industry. But past performance isn’t indicative of future performance. What worked yesterday may not work tomorrow. Considering the time commitment and difficulty of building an investment portfolio and monitoring it in the hopes of beating the market, many are ready to simply let the market decide instead.
Investing in an index like the S&P 500 over a long time frame, like 30 years or so, may be a better strategy for many investors. As long as one can handle the inherent volatility that comes with investing in indexes, it could be the ideal way to invest for someone who has a longer time frame to retirement. However, when investors have 5 years or less until retirement, stock picking may be a better option, since they might not be able to fully recover from catastrophic losses in time.
Investors don’t have to look at designing an investment portfolio as simply a black and white endeavor. That is, you don’t have to either stock pick or invest in an index – you can always mix the two ideas. Investing part of your portfolio in a general index fund and holding it over the long term while also keeping a diversified portfolio of stocks (at least 10, and no more than 25) is a good way to keep all your options open.