Three Important Questions Stock Pickers Need To Be Asking

People love picking individual stocks. Despite the mountain of evidence that suggests that doing so is, at best, not likely to be profitable and, at worst, a reckless use of your hard-earned money.

In this article, I’m going to discuss the myth of the stock picker, the evidence that’s against stock picking, and list three important questions stock pickers absolutely need to be asking themselves.

What is Overconfidence Bias?

It’s not difficult to understand why so many people are drawn to the idea of investing in individual stocks in hopes of “beating the market.” Except for Warren Buffet and a handful of other people currently living on the planet, thinking you can beat the market is a clear sign of overconfidence.

Overconfidence bias is when people overestimate the probability of a good outcome and underestimate the probability of a bad outcome.

Overconfidence can be a helpful thing in some areas of life. For example, my thinking I was in the same league as my wife when I met her was a clear display of overconfidence.

When it comes to investing, overconfidence can have terrible impacts on your money. Investors and traders who pick individual stocks are downplaying the very real possibility of a bad outcome.

Research Suggests Stock Picking is a Bad Idea

If you currently own individual stocks, I urge you to read the 2018 paper by Hendrik Bessembinder from Arizona State University entitled “Do Stocks Outperform Treasury Bills?”. Here is a summary of the paper and its most relevant findings.

• Bessembinder studied the lifetime performance of picking individual stocks in the U.S. dating back to 1926.
• 60% of all stocks that he studied had a lifetime return of less than a 30-day U.S. Treasury Bill (T-Bills).
• That means that you would have had better returns if you had invested in T-Bills (which are risk-free) than if you had invested in the majority of U.S stocks since 1926.
• 4% of U.S stocks accounted for 100% of the gains in the U.S. stock market since 1926.
• Bessembinder concluded that “The results help to explain why poorly-diversified active strategies most often underperform market averages.”

The results of this research make it clear that picking stocks is a losing game. By picking individual stocks, you have a higher probability of underperforming a risk-free asset than you do of beating the market.

“Typically, I don’t advise clients to pick individual stocks on their own, I just think it’s a fool’s errand to pick individual stocks,” said Erik Nero, CFP, CCFC, Founder & President, First Step Wealth Planning. “There’s just too much that’s outside of our control with respect to the performance of an individual stock.”

As Vanguard founder Jack Bogle put it, “Don’t look for the needle in the haystack. Just buy the haystack”.

Translation: Don’t Invest in individual stocks, invest in the entire market.

The Most Likely Outcome Isn’t Pretty

The worst-case scenario for stock pickers is that the stock they pick goes to zero. While this is rare, it is not unheard of. Famous examples include Lehman Brothers and Enron.

While it is rare that investing in individual stocks would result in a total loss of your investment, a very real possibility is that the stock you buy drops in price and never recovers to the price you originally paid for it.

A 2014 study conducted by J.P. Morgan looked at all publicly traded stocks in the U.S. dating back to 1980. 40% of the 13,000 stocks in the study declined by more than 70% from their peak value and never recovered.

Translation: you lose a chunk of your money.

Three Questions Stock Pickers Need to Ask Themselves

If you are the type of person not convinced by the data (which is probably the case if you are a stock picker), I will make a non-data-based argument against picking individual stocks.

Here are three questions to ask yourself before picking individual stocks.

Question 1: Who is on the other side of this trade?

Every time you buy a stock, there is someone else on the other end of that trade who is willing to sell that stock to you at the price you asked for.

Ask yourself, who is that person? The odds are that it is a financial professional with a great deal of experience or knowledge of the company being traded.

Question 2: Why is the other person selling this stock?

The person on the other end of the trade currently owns that stock and is willing to sell it to you.

Ask yourself why they are willing to sell.

The most likely reason is that they feel the stock is overvalued at its current price or has low expected returns in the future.

Question 3: What do I know that the other person does not?

Once you have asked yourself who you are trading with and why they are willing to sell, the final question you need to ask is, what do you know that the other person does not?

What information do you have about the company you are investing in that makes you confident that buying it at its current price is a good investment? Keeping in mind that the person on the other end of the trade thinks it’s a good idea to sell this stock at its current price.

Putting it together

If you think through all three questions, here is the picture you begin to paint about picking individual stocks.

• I’m likely trading with a professional who has deep knowledge about the company in question and years of experience in financial markets.
• This person has the opposite view on this stock as you do. While you think it’s time to buy, they think it’s time to sell.
• If you’re being honest with yourself, it’s highly unlikely you have more information than the person you are trading with.

This paints a pretty clear picture to me. People pick stocks because they are overconfident in their ability to do so. If you look at historical data or ask yourself the three questions listed above, you come to the same conclusion. Picking individual stocks is a bad idea.

Seek Professional Advice 

Despite the limited chances of success, some people may still be keen to try picking individual stocks. They would be well served by discussing their approach with their financial advisor before making big changes to their portfolio.

“We still have clients who would like to take a small position in a company that has the potential to be the next winner,” said Joe Dunat, MBA, Wealth Advisor at Sturkie Wealth Management. 

“But like with everything, it’s done with a balanced approach to the overall financial plan.” 

“For those people who really want to do it as a hobby, I will help them develop a thesis for owning that stock and help them define the expectations of what that stock’s value is,” said Nero. “That involves understanding the company, the accounting fundamentals, and how that company will be at an advantage against other companies in that industry, etc.”

“Yet I tend to find once I have that conversation with clients, most of them drop off by the wayside, most of them don’t want to do the work necessary to do that,” said Nero.

Additional Expert Voices

We asked financial advisors in the Wealthtender community for their insights when helping clients interested in picking individual stocks. Here’s what they said:

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Picking stocks to manage on your own is similar to owning any investment. Take an investment property, for example. With real property, you are choosing to become a landlord and need to take into account all of the factors that impact the rental prices you set, the tenants you choose, and the terms of the leases you set. You benefit from the rental income but must tend to your tenants and the upkeep of the physical property to ensure the cost and time is worth the return.

Individual stocks are no different. You may benefit from the growth or dividends, but they need tending to by way of your attention on their performance, projected future performance, and decisions that affect their valuation. The risks you incur with individual stocks have much more to do with business risk, possibly international risk if the company is global, and factors unique to that sector and specific industry that go beyond market risk.

Just like a property, the investment of your time involved in the research and analysis has to be something that yields a positive ROI, as well as something that you enjoy doing. This means reviewing a wide variety of industry-related publications but really knowing what leading indicators to focus on that will impact the individual positions you hold so you can make wise decisions for future trades. – Michael Raimondi, Clarus Group LLC

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We love it when clients take an active role in their own investments for their retirement. Before we give any advice, we want to know if clients have a disciplined approach or if they are just subscribing to a newsletter. Some of the questions we ask our clients include: What is your process? How do you know when to buy? When to sell? How are you measuring risk on your overall portfolio? What is your continuity plan? Subscribing to newsletters is great for supplemental information, however, without a disciplined process, clients typically tend to underperform.

The most common risk we have seen is that one spouse has a complex investment strategy, has a health event, and then their spouse/family sells everything. This could be at the worst possible time and potentially trigger a lot of taxes on good long-term investments.

Starting a relationship with an advisor who manages a portion of the assets could help in the continuity of the overall portfolio, even when you are managing a bulk of the investments.  That relationship is an opportunity to communicate your investment strategy, bounce ideas off each other, and allow your spouse to start a relationship with someone that both of you trust in case you are no longer able to manage your investment strategy.

In the future, this advisor may take on some of the investment management, but they are aware of your liquidation strategy and tax situation, saving your family from a large tax bill. – Amar Shah, Client First Capital

What to Read Next:

• How Much Does a Financial Advisor Cost?
• What is a Certified Financial Planner?

About the Author

Ben Le Fort

Ben Le Fort is a personal finance writer and creator of the online publication “Making of a Millionaire.” He has been passionate about personal finance ever since graduating University with $50,000+ in debt.

In the eight years following graduation, he paid off all of the debt and built a seven-figure net worth. Ben holds a Bachelor’s degree in economics from Acadia University and a Master’s degree in Economics & Finance from The University of Guelph.

Ben lives in Waterloo, Ontario, with his wife, son, and cat named Trixie.