Trying Hard at Stock Picking Doesn’t Help Much
In a post that inspired many debates among commenters, My Own Advisor asked why we should bother to buy individual stocks at all. In a rebuttal to indexers, one commenter, Pullingmyselfup, asked the following question (lightly edited):
It’s true that indexing proponents discourage people from trying to pick their own stocks and suggest they just buy an index of all stocks. Golfers can improve through training and practice; why can’t stock pickers improve?
The truth is that we can improve our abilities to analyze stocks. But investing offers an alternative not available to golfers. Imagine if you had the option to receive the average prize at the next professional golf tournament without doing anything at all. Instead of hoping for some natural golf talent, buying equipment, spending years building skills, and traveling to tournaments, you just sit on your couch and collect the average player’s prize.
Of course, we don’t have this option in golf, but we can do it with investing. Instead of competing with the bulk of investing dollars controlled by professionals, we can just get their average performance by investing in index funds.
It’s true that if I work at it I can learn to analyze stocks better. But I won’t become better than the average professional investor. I can shrink the gap between me and the pros, but I’ll remain better off just buying index funds.
There are a small number of investors who may be able to build the skills necessary to compete effectively with investing pros, but almost all of us are better off focusing on a sensible asset allocation and buying index funds.
There are some who will say they’d rather play golf than sit on the couch. So would I. But I know I’ll never play well enough to compete with the average golf pro. Sometimes for amusement I look at some individual stocks, but I don’t buy them because I can’t compete with investing pros.
Stock picking isn’t the only activity where the option of just taking the average result is available. Consider poker. In a friendly game where there are no pot rakes or seat fees, the average player makes nothing at all. The money shifts around, but the total amount held by all players stays the same. If you want to get the average result of all players, just don’t play. In fact, you’ll beat the average of the other players this way after we consider costs like pot rakes and seat fees. A similar thing happens with indexing. Index investors actually get better results than investing pros after we consider the lower fees that indexers pay.
The number of active stock pickers who beat indexing over the long run is very small, but the number of active stocks pickers who say they beat indexing is very high.
“Why is investing the only job, hobby, or activity where people are told not to try?”
It’s true that indexing proponents discourage people from trying to pick their own stocks and suggest they just buy an index of all stocks. Golfers can improve through training and practice; why can’t stock pickers improve?
The truth is that we can improve our abilities to analyze stocks. But investing offers an alternative not available to golfers. Imagine if you had the option to receive the average prize at the next professional golf tournament without doing anything at all. Instead of hoping for some natural golf talent, buying equipment, spending years building skills, and traveling to tournaments, you just sit on your couch and collect the average player’s prize.
Of course, we don’t have this option in golf, but we can do it with investing. Instead of competing with the bulk of investing dollars controlled by professionals, we can just get their average performance by investing in index funds.
It’s true that if I work at it I can learn to analyze stocks better. But I won’t become better than the average professional investor. I can shrink the gap between me and the pros, but I’ll remain better off just buying index funds.
There are a small number of investors who may be able to build the skills necessary to compete effectively with investing pros, but almost all of us are better off focusing on a sensible asset allocation and buying index funds.
There are some who will say they’d rather play golf than sit on the couch. So would I. But I know I’ll never play well enough to compete with the average golf pro. Sometimes for amusement I look at some individual stocks, but I don’t buy them because I can’t compete with investing pros.
Stock picking isn’t the only activity where the option of just taking the average result is available. Consider poker. In a friendly game where there are no pot rakes or seat fees, the average player makes nothing at all. The money shifts around, but the total amount held by all players stays the same. If you want to get the average result of all players, just don’t play. In fact, you’ll beat the average of the other players this way after we consider costs like pot rakes and seat fees. A similar thing happens with indexing. Index investors actually get better results than investing pros after we consider the lower fees that indexers pay.
The number of active stock pickers who beat indexing over the long run is very small, but the number of active stocks pickers who say they beat indexing is very high.
Everyone should know their own limitations, is my thoughts on why I don't buy individual stocks (any more).
ReplyDelete@Alan: Agreed. It's been a long time since I bought an individual stock. But I've taken my sweet time selling the ones I already own.
DeleteAgreed, it's hard to sell TD and BCE even though I know I already own them in the Indexes I own.
DeleteThe poker example is perfect. In fact there is a lot of other activities where one comes ahead the average just by doing nothing. Everyday I ear people complaining over gas price but they keep driving around for any reason. I prefer making a list of what I need and stop by on my comute from work or pool all of them into 1 monthly run.
ReplyDelete@Le Barbu: Glad you liked it. When it comes to gas prices, people focus on the fill-ups rather than their driving around. If fuel gauges showed your dollars counting down rather than just showing what fraction of a tank is left, people would drive a lot less.
DeleteMichael, your right on that one. I would make this device showing the REAL cost of driving wich is 3-4x the gas depending of your ride. I track all of my car expenses including maintenance, licences and even oportunity cost and I facepalm when some say driving 200km is just like 10$! If you run the maths properly, it's 20$ of gas and a total of 80$ for an average car, leave alone a F-150!
Delete@Le Barbu: You're absolutely right, but it's hard to convince people of this. They allow that maybe cars are expensive for some people, but they're convinced their own car isn't as expensive.
DeleteI love giving you content :)
ReplyDeleteGolf can be used as an analogy to many of life's issues, financial included. The reality is, an average golfer is actually a decent golfer, they shoot better than 90 for 18 holes, if they count all their strokes.
If you could be an average golfer without any work I suspect most people would jump at the chance. The same should be true with investing.
I've learned to embrace indexing more in my portfolio but it's very hard to sell my babies/stocks since I see the dividends come in and over the last five years, I've had the same returns as XIU or XIC, about 9%.
Will it stay that way? We'll see but I'm not ready to sell the stocks I own or stop the reinvestment plans anytime soon.
Mark
@Mark: You've inspired my articles more than once, but I avoid the word "content" -- advertisers who don't care about quality of articles have ruined the word "content" for me.
DeleteI assume you mean the average pro is a good golfer? Among all golfers, the average honest score is over 100, even if you weight it by number of rounds played.
Unless you play with me, and my dishonest score is STILL 135!
DeleteI prefer to prefer to think of indexing as accepting the market return rather than the average return, as the market return is certainly way above the average return that all investors get. Active managers exploit this in their attempts to gather assets by asking " you don't want to get get just average returns, do you?"
ReplyDeleteA good friend of mine says he continues to be a stock picker, despite the evidence, because it's his hobby. So far, I've not been successful in trying to convince him to find a less expensive form of entertainment.
@Grant: Good point about the market return actually being an above average result. I've had similar experience with persuading others. I often get people who tell me they agree with me on indexing and soon afterward ask me what I think of a certain stock or the market in general.
DeleteThe trouble I have with indexing is it so counter-intuitive. Doesn't it seem reasonable that if you bought the top 500 companies in the S&P 500, then sold off the high flying market darlings, secondly sold off the poorly managed/poor business plan stocks and used the proceeds to double up on the best run companies that you would beat the market?
ReplyDeleteThe evidence is no, professional managers who spent +40 hours a week doing just this cannot consistently beat the index, what gives?
@Anonymous: I like your question. The short answer is that the collective investing pros tend to figure out which companies have good prospects and which don't. the prices of stocks reflect this knowledge. So, if you exclude the bad companies from your portfolio, you're owning the highly-priced companies. The ones that don't outperform by enough will cost you money. In the end, you're no better off than you were buying the index. Anyone with genuine stock-picking skill would look for mismatches between stock prices and business prospects. Just focusing on business prospects isn't enough.
DeleteWould be interesting to get a sample of investors and what their definition of "the market" is when they talk about beating the market, and also what their benchmark is when they talk about indexing.
ReplyDelete