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Investing 102

Deeper dives on diversification, wealth-building, and making the most of every investment

Why stock picking is not a good investment strategy

January 12, 2021

There are two reasons why novice investors feel defeated by the stock market:

  1. They think investing is like betting or gambling, and are intimidated by the idea of just ‘picking the right stocks’ in order to make money
  2. They think investing is like betting or gambling and spend way too much time and money day-trading, buying and selling stocks, and feverishly checking their portfolio — all the while giving away their money via transaction costs and fees.

Technology can make investing easy and fun. It is now extremely easy for an individual to start investing, with as little as $5. Apps have gamified the investment process — likely with the good intention of using colors and graphics to make investing less scary and more welcoming to a younger generation, but perpetuating the idea that the stock market is a game with winners and losers. Experts online claim that day-trading is a complex but surefire way to make money, and anyone can rake in thousands of dollars as soon as they buy a special course.

Picking individual stocks is simply not a winning strategy. Studies have shown that most active managers (people who get paid hundreds of thousands of dollars to pick winning stocks) have historically underperformed the market. Here are a few reasons why:

  1. Concentrated risk: A JP Morgan report that compares the Russell 3000 index — which, as the company notes, “represents approximately 98% of the investable US equity market” — between 1980 and 2014 with information on individual stocks, notes that “When computing the optimal risk-adjusted return for a concentrated holder…we find that 75% of concentrated stockholders would benefit from some degree of diversification.”
  1. Individual stocks have a higher risk of failure: The same report states that “When looking at how often a stock has what we call a ‘catastrophic decline’ — falling 70% or more and never recovering — we see that 40% of all stocks suffer this fate at some time in their history. And some sectors — like telecom, biotech and energy — saw higher-than-average loss rates.” As consumer trends and priorities shift, stocks that may previously.
  1. No one can predict the future: Many investors, even those who have been investing for years, think that they only need to spend more time researching and gaining knowledge in order to find the right stocks to invest in. While researching the market is always a good idea, it should not be done with the intention of predicting the market. Even if a company did extraordinarily well in previous years, there is no absolute guarantee that it will be able to replicate its success or keep up with competition in the future.

Does this go against what you’ve heard anecdotally from acquaintances who claim to have bought Amazon stock in the early 2010’s or who have gone “all in” on Tesla or any one of this year’s hot stocks? Sure, a short-term trader can make money – for a while, by sheer luck. People have lost all their savings by betting on or against the next big thing, be it tech, or pharma, or even telecom.

The answer to stock-picking: Diversification

Proper diversification of your portfolio is key to your investing success over the long run. By investing in many companies at the same time, you hedge your chances of failure. Even if a company fails or an entire sector fails to perform, your portfolio will be relatively intact. Most people buy ETFs (Exchange-Traded Funds) that offer diversification for a low fee. You should also only invest with money that you will most likely not need for 5-10 years. That gives your investment the chance to work for you over the years as your returns compound over time. Diversifying your portfolio by investing in low-cost ETFs has several advantages:

A bet on the US (and global) economy: The S&P 500 consists of the 500 biggest public companies in the United States. Other indexes, like the S&P Global 1200 (which captures 70% of the global equity cap), and Russell 3000 give investors more options to bet on the overall economy.

Lower trade fees: Buying and selling stocks to build a portfolio can be costly in terms of trading fees and commissions. However, most investment platforms offer access to their own S&P 500 index fund for no fee.

If you do want to trade individual stocks, it is possible to do so in a well-diversified portfolio. It is best to set weight limits on asset classes within your portfolio, perhaps something like this:

Good financial planning should be a bit boring. Decide on your financial goals, build an aligned portfolio, and then let your money grow over time. Not only does this keep costs low and save you extra work in tax season, but it also allows you to avoid knee-jerk reactions during periods of high volatility.

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