I’ve written on more than a few occasions about the active versus passive investing debate, which will likely never end due to everyone having different goals and preferences around their investments. And that’s how it should be. But today, I wanted to revisit why I think picking individual stocks isn’t the most optimal long-term investment strategy.
The data backing this argument is somewhat undeniable. The specific numbers vary slightly from year to year, but you can look through any market report for any equity market on Earth and you’ll see more or less the same thing — over a five-year period around 75% of actively managed funds don’t beat their benchmark. Around 95% of professional day traders end up losing money over a five-year period as well.
Keep in mind that these statistics measure professional money managers working full-time with a team of analysts. If these people can’t outperform the market with all of their time and resources, what chances do all of us with full-time jobs, family obligations, and other hobbies have at beating the market?
But I want to put aside that traditional, numbers-based argument for now. Instead, I want to focus on a philosophical dilemma that comes with picking individual stocks. The question is simple:
How do you know if you’re good at picking stocks?
Or in other words, how much of your success, or lack thereof, is due to skill versus luck?
Michael Mauboussin, the author of The Success Equation, gives a great framework for how to go about answering this question:
“There’s a quick and easy way to test whether an activity involves skill. Ask whether you can lose on purpose.”
I can purposefully miss 100 basketball shots in a row if I wanted to. I can purposefully miss every single putt on a golf course. I could purposefully be bad at my job.
However, am I confident in my ability to pick a list of ten stocks that will underperform the broader market over the next year? Not really.
When I was in college, I opened up a Robinhood account and began trading in it. I picked a handful of popular stocks and hoped that they would increase in value. As it turns out, they did. I outperformed the S&P 500 in the time I had the account.
What was the secret to my success?
I wish I could say it was due to my savvy analysis and skills as a stock-picker, but it wasn’t. I got lucky. It might be unfair to say that most people tend to wing it like I did when picking stocks, but in my experience, that isn’t far off.
Let’s say you bought a stock because of some news you heard about the company and the stock price rose. How do you know if the reason for the stock going up was because of the news you read or because of some other factor that you didn’t even know about? The answer is you don’t. You may convince yourself that you know what’s going on, but do you really know?
This is the philosophical dilemma I’m talking about.
Luck and skill are so difficult to untangle because, as Mauboussin puts it:
“Even if we acknowledge ahead of time that an event will combine skill and luck in some measure, once we know how things turned out, we have a tendency to forget about luck.”
This can be a dangerous game to play because taking credit for a positive outcome can lead to overconfidence. Bill Bernstein, an investment writer, has written about the hidden dangers of picking individual stocks:
“The very best way to learn about the dangers of individual stock investing is to familiarize yourself with the basics of finance and the empirical literature. But if you can’t do that, then, sure, what you have to do is put 5% or 10% of your money into individual stocks. And make sure you rigorously calculate your return, your annualized return, and then ask yourself, “Could I have done better just by buying a total stock market index fund?” And pray that you don’t get really lucky, because if you get really lucky, you may convince yourself that you’re the next Warren Buffett, and then you’ll have your head handed to you when you’re dealing with much larger amounts later on.”
Now, money earned by luck is still every bit as green as money earned from skill. There are no extra points for being right for the right reasons and people get lucky in the stock market all the time. However, I’m not sure I want to rely on luck as my long-term wealth-building strategy. For most people, luck runs out at some point.
Personally, I just don’t love the idea of spending a lot of time and effort doing something that may or may not produce superior, or even positive, results.
If you enjoy picking stocks, then go for it. I typically find it helpful to create some rules around it. Maybe you can allocate a small portion of your overall portfolio toward day trading so that if you end up not being great at it, your livelihood and financial future don’t depend on it.
Thanks for reading!
Jake Elm, CFP® is a financial advisor at Dentist Advisors. Jake a graduate of Utah Valley University’s nationally ranked Personal Financial Planning program. As a financial advisor at Dentist Advisors, he provides dentists with fiduciary guidance related to investments, debt, savings, taxes, and insurance. Learn more about Jake.</em