Why Picking Stocks is Even Harder Than You Think

“Investing is simple, but not easy.” – Warren Buffett

There are many factors one has to consider when buying a stock.

You must determine the competitive advantage that the company has over its competitors.  You must gauge the consistency of their operating history and what the long-term prospects are for the company. It also makes sense to look at how rational the management team is and whether or not they are open and honest with shareholders.

And once you determine all of those basic qualities of the company you must actually determine the attractiveness of the stock as an investment using some measure of valuation.  Great companies aren’t always great stocks and vice versa.

You need to figure out whether the stock is trading at a discount to its intrinsic value or future growth rates.  This can be challenging, to say the least.

You also have to be able to pick the correct stocks that will outperform the broader stock market over the long-term.  Otherwise, you should just buy the index.

What makes this even more challenging is the fact that over the long-term the pool of available stocks that meet all of these criteria is a lot smaller than you think.

Larry Swedroe shares some interesting facts in his CBS Moneywatch column this week:

“For the period 1983-2008, the Russell 3000 (which represents about 98 percent of the investable market) returned almost 10 percent a year, producing a total return of 1,074 percent! During this period, about 40 percent of stocks had a negative return and about 20 percent of stocks lost nearly all of their value. Sixty-four percent of all the stocks underperformed the Russell 3000. Clearly a small number of stocks are responsible for a majority of the gains — about 10 percent of stocks recorded huge wins in excess of 500 percent.”

This shows how top heavy stock market returns can be.  Since the stock market is a market of stocks you would assume that most of them trade right along with the market averages.  Obviously this is not the case.  Swedroe continued with another interesting study:

“For another example, my colleague, Vladimir Masek, found that of the 500 companies in the S&P 500 as of October 1, 1990, only 302 (60.4 percent) were even still in existence 10 years later. Of the 302 (which certainly includes survivorship bias, as many companies that didn’t survive in all likelihood produced poor returns), only 79 (26.2 percent) beat the Vanguard 500 Index Fund (VFINX).”

Another study I read found that from 1957-1997 the S&P 500 was up over 8,500% with reinvested dividends.  But of the 74 stocks that stayed in the index for that entire period, only 12 of them actually outperformed the index itself.

Remember that the S&P 500 is generally the largest 500 publically traded companies in the U.S. stock market.  The attrition rate here is huge.  Obviously, there are takeovers, mergers, divestitures, private equity buy-outs, company break-ups and all sorts of corporate activities that take place over the years that can account for some of these numbers.

But there are also bankruptcies and failed companies.  This shows how much of the market’s return comes from the top echelon of companies and stocks over the years.

LESSONS
This does not mean that it’s impossible to pick winning stock investments.  There are still inefficient, underfollowed parts of the market where investors can find stocks that can outperform (small caps, spin-offs, value stocks, contrarian plays).

And there are investment themes that have shown to be very profitable for investors when they have a long-term mindset (dividend reinvesting, quality stocks).

Make sure you have a well-tested, systematic process in place before picking stocks.

These numbers show you that the amount of great stocks is a lot less than you think.  It is not a matter of having half of all stocks outperform and half of all stocks underperform and the market return is directly in the middle.  Unfortunately it’s not that easy.

There are really great stocks that account for the majority of all stock market gains.  There are also more poorly performing stocks than most investors realize.  That makes your job even harder.

HOW TO INCREASE YOUR ODDS OF SUCCESS
To increase your odds of success in picking stocks you can use these numbers as a wake-up call.  Make sure that you are not putting your entire investment portfolio into only a handful of individual stocks.

Warren Buffett can do this successfully but most investors cannot.  I understand why individual investors like to pick stocks.  It’s fun and it forces you to continuously learn about companies, products, industries, the economy and the market in general.

If you would like to continue picking stocks, try to limit the amount of your investments in individual stocks to no more than 10% of your portfolio.  If 1 out of 5 stocks will lose nearly all of its value and you happen to buy one of these stocks, you don’t want it to make up a huge part of your portfolio and put your retirement funds at risk.

Keep a diversified portfolio of index funds for the remaining 90% of your portfolio to keep you honest.  By limiting your tactical investments to only 10% of your overall portfolio you minimize the risk of a total loss of capital.  Stocks can and will go to zero, but an entire market of stocks will not.

Knowing the odds of stock picking can be very beneficial to investors.  In fact, successful investing comes down to being able to determine a set of probabilities and then weighing them accordingly (that’s why Buffett is a Bridge player in his spare time and learned about handicapping odds at the horse racing track when he was young).

It would be great to pick one of the stocks in the top 10% and hit a home run for your portfolio.  But would you rather have a 10% chance of a really large gain or a 75% chance of outperforming the rest of the stocks in the market with a simple index fund?

For the majority of investors, the choice seems both simple and easy to me.

Sources:
Stock market gains come from few top performers
The Trillion Dollar Mistake

Here is what I’ve been reading this week:

• A Lesson From Buffett: Doubt Yourself (Wall Street Journal)
• Confirmation bias and perma-whatevers (Abnormal Returns)
• 25 Famously Wrong Predictions (The Chive)
• Lessons From The Warren Buffett Way (Everything About Investment)
• The Dull Task of Decoding 401(k) Fees Matters (NY Times)
• Modern-day Robin Hood applies business skills to philanthropy (60 Minutes)
• Income stability matters in your portfolio (CBS Moneywatch)
• Commodities as Portfolio Insurance (Index Universe)
• Just How Good Is Warren Buffett Anyway? (The Reformed Broker)
• Ignore all forecasts (CBS Moneywatch)

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