We’ll be perfectly honest about something: whenever we tell someone we work at a financial planning firm, they ask us in a half-joking and half-serious manner, “Oh, in that case, do you have any stock tips for me?” They’re mostly being polite, of course, but their question speaks to a larger issue: many investors still believe in the false notion of stock-picking.
What is stock-picking? It’s fairly self-evident and straightforward. Rather than investing in diversified mutual funds or exchange-traded funds (ETFs), a stock-picker chooses a small number of individual stocks they believe will outperform the overall market. In other words, they are attempting to beat the performance of those mutual funds and ETFs.
So, what’s wrong with stock-picking? What’s wrong with trying to beat the market? Unfortunately, there are several problems, including:
- There is very little evidence to suggest stock-picking produces better returns than the broad market, even among the highly-trained, highly-paid Wall Street. professionals who attempt it.
- Holding a few individual stocks does not provide for a well-diversified portfolio, which exposes the portfolio to unnecessary risk.
- Buying and selling individual stocks produces significant transaction costs, including commissions and taxable capital gains.
- Monitoring a portfolio comprised of individual stocks requires constant oversight and is therefore more likely to cause investors to make rash, short-term decisions based on daily market fluctuations.
So, why do some investors maintain the outdated philosophy of stock-picking? We have some theories:
- Investors are attracted to the idea of beating the market with shrewd stock picks. It seems exciting. Mutual funds seem boring by comparison.
- Stock-picking fuels a person’s overconfidence. A calm, steady investment in a mutual fund does not light up our egos the way picking a well-performing stock does.
- People will focus on their overperforming stocks and ignore their underperforming stocks via confirmation bias, i.e. they see what they want to see and ignore what they do not want to see.
- Movies, TV shows, and the news media make stock-picking look exciting and attainable. Wheeling and dealing. Wall Street traders yelling. Selling short, going long, options, credit default swaps. Sure, it makes for good entertainment, not necessarily good investing. Would anybody watch a TV show about investing in index funds?
Stock-picking still has its adherents, no doubt. But we believe Modern Portfolio Theory (which will be covered in-depth soon), with its emphasis on long-term, low-cost, and well-diversified mutual funds and/or ETFs, generally offers the average investor better performance (and fewer headaches) than stock-picking. Evidence supports the approach we apply to your portfolio. The Hollywood screenwriters can keep you entertained with stock-picking, but we’ll keep you comfortable with our strategy.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice. Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.