How Much Life Insurance Do I Need?
The Role Life Insurance Plays in Your Finances The purpose of life insurance is to...
Previous Article: Personal Capital Review: Wealth Management for 2020 and Beyond
Next Article: Buy Ahead and Save BIG
We want to be transparent about how we are compensated. Some links in articles are from our sponsors. Learn more about how we make money.
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.
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.
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.
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.
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.
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.
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.
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.
If you think through all three questions, here is the picture you begin to paint about picking individual stocks.
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
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.