Financial Markets

Why You Shouldn’t Pick Stocks

Picking stocks can be fun and exciting.  I’ve done it, most of you have as well.  Fun and exciting does not necessarily correlate to investment success.  In all the finance textbooks I had to read it never said anywhere that investing was supposed to be fun or exciting.

People come to me often and say something along the lines of “Company X is about to make a new widget that everyone is going to need, let’s look at buying some of their stock so we can take advantage” or “Company Y has been in business 50 years, pays a great dividend, makes a ton of money, so it should be a rock solid investment”.

These are not valid reasons to pick a stock.  If there is something you know about a company, chances are many others are in the know as well and it’s likely already priced into current market prices.  If enough people know that a $50 stock will go to $75 next month, it would go to $75 TODAY.  The market is an amazing machine at pricing securities efficiently, which means having an edge is extremely tough to come by.

Markets are not perfectly efficient, but I believe they are efficient enough to where the chances of consistently exploiting mispriced opportunities are very low.

At an advisor event in 2013, attendees were asked to write down a best guess for the number of jellybeans in a large jar.  The guesses ranged from 409-5,365.  The average of the guesses was 1,653.  The actual number of jellybeans was 1,670.  The collective wisdom of the guesses was shockingly close to the actual amount.

Stock prices are also set by the collective guesses of all market participants.  When picking a stock, you are stating that the collective wisdom of the market has made an error in pricing.

A friend of mine in the industry put it this way, “Nobody would debate the fact that the collective knowledge of the internet is smarter than any single person, yet there are many individuals out there that believe they are smarter than the collective wisdom of the market”.

One of the only reasons a person would buy an individual stock would be to try and outperform the market.

Is outperforming the market possible?  Yes.  Likely?  No.  According to the SPIVA U.S. Scorecard 2017 mid year update, 84.57% of all domestic U.S. equity funds underperformed their respective benchmarks over the trailing 15 years.  The data is similar for the prior 3, 5, and 10 year periods as well.  What’s interesting is that many industry professionals generally will say that small caps are more inefficient so a good manager can add value, but over the past 15 years 94.43% of ALL small-cap funds underperformed their benchmark.

Those are the professional investors, so what do you think your chances are as an individual who does not spend near as much time in research?  Most of the pros are smart people and they have access to better research tools and technology, yet the overwhelming majority still underperformed.

Why can we not just focus on the companies that are established, pay good dividends, and have a sustainable business model?  For one, dividends do not matter, but I will post write about that another time.  According to “More Than You Know” by Michael Maboussin, Charles Dow created his first list of industrial stocks in 1896 (at this time a technology sector didn’t even exist!).  Here are the major companies at the time:

American Cotton Oil
American Tobacco
Chicago Gas
Distilling and Cattle Feeding
General Electric
Laclede Gas
North American
Tennessee Coal & Iron
U.S. Leather
U.S. Rubber

Remember when I said investing isn’t supposed to be exciting?  Well how could it be exciting in 1896 if you had to speculate in companies with names like U.S. Rubber?  Just reading that list of companies bores me.  I only recognized two of them.  General Electric has stuck around but what happened to the rest?  A century from now I would bet the names of the top companies will be very different from today as well.  The list will most likely include many companies that are not yet in existence.

Most investor chatter today centers around tech stocks, but imagine playing croquet with your buddies in 1896 and speculating about U.S. Leather’s projected earnings.  There are no certainties for any company.

100 years from now will Amazon rule the world?  That would surprise me.  Many have forgotten that the largest company in the U.S. (by market capitalization) in the year 2000 was Cisco Systems.  The peak market cap was $555.4 billion.  Today it is valued at $164.7 billion.

Picking stocks has worked for a few, but not the masses.  It might be wiser for most of us to diversify across companies, sectors, and countries to rid your portfolio of idiosyncratic risk.

Views expressed are those of the author, are not necessarily those of Raymond James Financial Services and are subject to change without notice. Information contained herein was received from sources believed to be reliable, but accuracy is not guaranteed. Information provided is general in nature, and is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. Past performance is not indicative of future results. There is no assurance these trends will continue or that forecasts mentioned will occur. Diversification and asset allocation do not ensure a profit or protect against a loss. Investing always involves risk and you may incur a profit or loss. No investment strategy can guarantee success.  Raymond James Financial Services is not affiliated with and does not endorse the opinions or services of Michael Maboussin.