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 3 important questions stock pickers absolutely need to be asking themselves.
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.
The 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, me 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 it’s 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 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.
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
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.
3 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.
Ask yourself, who is that person? Odds are is that it is a financial professional with a great deal of experience or knowledge of the company being traded.
Question 2: Why is that 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 do 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 its 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.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions