Young & Invested: Why I don’t invest in individual stocks
Presenting the argument against direct stock picking.
At my worst, I am an emotional investor.
In my article last week, I outlined emotional biases investors face when making decisions – admittedly I used to be privy to most. My investing history is littered with individual stock picks with varied returns; however, the overarching theme I noticed is that I could not beat the market.
What I mean by this is that my past portfolios solely consisted of a few hand-picked growth stocks that I falsely assumed would reward me with astronomical returns. Of course, some of these picks did considerably well but were weighted down by the majority of failures that sat in my portfolio.
The S&P 500 returned 25% last year whilst it’s favourite peer the Nasdaq Composite returned 29%. Unless you managed to ride the Mag 7 wave which returned 67%, it is likely a portfolio of hand-picked stocks would have underperformed these indices.
The ASX 200 lagged the US but ended 7.5% up thanks to a strong push from the big 4 banks. Notably, former ASX darlings in the energy and materials sector had returns that would have unnerved a seasoned investor.
Define a goal and strategy
The choice between choosing individual stocks and simply investing in index-tracking vehicles lies in your investing goals and therefore your strategy. There is no denying that every investor wants to chase the highest returns possible. However, this poses the question of whether this encourages poor behaviour. In my experience, it certainly does.
Investing for short or intermediate goals tend to be a game of probability. Despite the general trends of markets appreciating over time, having a shorter horizon for a withdrawal increases the likelihood of settling at a loss.
Since I am largely undecided about homeownership and have no need for a large withdrawal of funds any time soon, my investing goal is quite simple. My primary aim is to growth my wealth over time and achieve higher returns than I would earn in a high yield savings account. More tangibly, I have set myself the goal of a $100,000 portfolio (excluding superannuation) by the age of 30.
Due to the nature of my income, I intend to dollar cost average ~$1,500 monthly until I reach this number. Of course, my contributions may increase over time, meaning I may achieve this quicker than planned, however I maintain a conservative estimate for now. Achieving this in my desired time horizon requires an approximate return of 8%, something I believe can be attained through collective investment vehicles.
The important factor here is that this goal is feasible and does not require me to seek eyewatering returns to achieve it. Defining a clear goal and knowing how to get there helps avoid a performance chasing trap.
Do you have an investing edge?
In how to define an investment strategy, my colleague Mark LaMonica covers the types of investing edge an individual can have to compete with others in the market. In short, there are four primary things that give investors an edge, those are structural, informational, analytical, or behavioural advantages.
Below is a brief summary of what each entail:
- Analytical edge – better use of existing information or deep knowledge of an industry
- Informational edge - access to more or better information
- Behavioural edge – better control of emotions and actions
- Structural edge – absence of career or industry pressures faced by professionals
In the past, my experience with investing was characterised by poor decision making that stemmed from emotional and behavioural biases. Unfortunately, it is thanks to the losses I consequently made that I have adopted a more disciplined approach with my portfolio and the goal that drives it. That has led me to believe I have a soft behavioural edge. This manifests itself in exercising patience, discipline and emotional control over what I choose to invest in and the frequency.
In my line of work, I am surrounded by an abundance of quality research on investment opportunities, and it is often tempting to pursue the ones I feel confident in. However, from my experience I know that I don’t behave well with direct equity holdings. For me, spending time overanalysing individual stocks and checking markets to see whether my holdings are affected by macro events is often time wasted. The world is constantly evolving meaning owning 10+ holdings can be an exhausting exercise.
Can you pick a winner?
I know that individual shareholdings do not require you to be right all the time. In fact, my colleague Mark LaMonica demonstrated this in his article are you better off in direct shares instead of ETFs? Mark explored a hypothetical Australian investor with 20 holdings and an equal allocation of 5%. This investor owned 19 shares that didn’t appreciate at all over the past five years, however the 20th share was Pro Medicus. Mark found that over the past 5 years that portfolio would have slightly outpaced the ASX 200 from a price return perspective at 22.82% vs 22.61% for the index.
Stock picking is a tough game with even Warren Buffet admitting that it is difficult. I personally do not favour my odds or ability to pick the next Pro Medicus nor believe that the potential opportunity cost of picking losers is worth it to potentially sacrifice returns and achieve my goal quicker.
Economist, Hendrik Bessembinder et al published a paper on long-term shareholder returns using evidence from 64,000 global stocks from 1990 to 2020. The study found that the best performing 0.25% of firms accounted for half of the global net wealth creation and the best performing 2.4% of firms accounted for all net global net wealth creation. These results invigorate the active vs passive debate as the findings indicate the wealth created by stock market investing is largely attributed to large positive outcomes of only a relative few companies. Bessembinder et al argues that the results reinforce the desirably of investing in a broad passive index for investors who lack a comparative advantage.
There are two things we can deduce from these findings. The first is that given the small concentration of stocks that create market gains, stock picking may seldom produce positive long run returns and therefore passive investing in an index is the favourable option. On the other hand, given this concentration, the returns reward for the individuals who can successfully pick winners are tenfold.
Our study
The Morningstar Active/Passive Barometer is a study that measures the performance of active funds against passive peers across trailing 3,5 and 10 year periods. The research spans over 800 open-ended strategies domiciled in Australia across nine categories.
Whilst certain categories like Australia mid/small-blend favoured active managers, passive managers generated better returns in the world large-blend category. Naturally the world large blend category is dominated by US market exposure meaning the increased concentration at the top (buoyed by the rally in the ‘Magnificent Seven’) has been a significant contributor to passive outperformance.
Interesting, the Australia large blend category was mixed with the overall active/passive performance argument hanging in balance. Active managers in this space can certainly lay claim to intermitted periods of outperformance, however consistent demonstrations of beating cheap passive investments remain a challenge for most.
What can we take away from this?
Investors are welcome to draw their own conclusions, but what this tells me is that even investment professionals struggle to beat the index in the categories I invest in. So, what are my chances of stock picking and outperforming a career investor? The answer is very little.
Of course, active funds have an advantage in the Australian mid/small category due to the nature of the Australian small cap environment. As I previously explored in an article on small caps, the ASX Small Ordinaries has a unique sector composition that is dominated by an abnormally high number of unprofitable businesses, primarily in the mining space. This builds an avenue for active managers to play on pricing inefficiencies and under-researched companies.
Admittedly, I am not an avid investor in small caps (after a few unfortunate pickings in the mining space), nor do I have the extensive resources at hand to simulate the advantage that active managers have in this space. Therefore, I would certainly not chance hand picking stocks in this category.
It is important to note that holding passive investments does not automatically make you are a passive investor. Individuals can hold passive assets but trade them at frequencies that negate the crux of being a passive investor. The foundation of the passive strategy revolves around the buy and hold mentality that avoids frequent transacting.
Buffet’s take
World renown investor Warren Buffet famously handpicked several value investments leading his company Berkshire Hathway, a former textile company to become the largest global conglomerate. We provide an expansive coverage on Buffet’s investing strategies and how he made his fortune, however the most important piece of advice I have heeded is his warning to the average investor. From an annual Berkshire meeting in 2021, Buffet notably stated that “I do not think the average person can pick stocks.” He further emphasised this in the same meeting by recommending investors pick a vehicle that simply tracks the S&P 500 index.
Conclusions
Given the discussion above, I do believe there can be merit in individual stock picking, however compelling research indicates that this is often easier said than done. Building on empirical evidence, a large aspect of investing is also doing what works best for you.
The purpose of this article isn’t to sway opinions toward either option, rather simply emphasize the difficulty of picking the long run achievers. Your ultimate decision should be based on your investing goals.
Previous Young & Invested column:
- Young & Invested: Can millennials afford to have children?
- Young & Invested: Is University still worth it?
