Learning about investing is unlike so many other tough topics. Just like anything else, the more you learn, the easier it gets. However, unlike most subjects, it does not get easier because you suddenly learn how to beat the market. The opposite happens. The more you read about investing, the more you will realize how many things can impact the market and how unknowable facets of individual stocks are out of your control. In the end, you realize that investing in individual stocks is a loser’s game because the complexity of life and human nature make it next to impossible.
The simpler passive index fund approach to investing wins out in the end for many reasons. So, if you’ve ever wondered, “Should I invest in individual stocks” this post is for you.
This might be the first of many posts on this topic, as there are certainly more than just five reasons. However, in this post, we will discuss 5 reasons why investing in individual stocks is a losing game.
1. Humans Find Patterns in Anything
Since the beginning of time humans have gazed at the skies and made shapes out of nothing. We see bears and warriors like Orion in the constellations. Orion is even holding a bow! During the day light, we see dinosaurs and dragons in the clouds.
This phenomenon is intrinsic to who we are as human beings. Long time readers know that I love a good sports analogy that translates to personal finance. Sports has problems with seeing patterns, too.
For the sports fans out there, you have probably heard an announcer on TV label a player as having a “hot hand” while watching a basketball game. The player has made a few baskets in a row. Surely, the next one has a better chance of going in, too. Right?
It will probably disappoint you, but it has been studied and the “hot hand” isn’t real. That player has the same statistical chance to hit the next basket as they always do. Better players still have a higher chance of making the next basket than worse players, but they are at no higher chance than they normally would be shooting baskets.
This same phenomenon happens in the stock market when we try to read the charts.
This is classically called “technical analysis”. Unfortunately, people that are paid to do this are no more successful than anyone else, and over time any success they have will revert back to the mean.
Just like looking into the clouds, these technical analysts see “cup and handles” in the charts. Or was it a “head and shoulders”?
That stock is no more likely to be “hot” than the dragon in the clouds is to becoming real. We have to ignore this human tendency, and make things simple. Otherwise, we will fall prey to this folly time and time again.
2. Life is Unpredictable
Life is unpredictable. I don’t need to tell this to the readers of this blog who are mostly medical professionals. We see that every single day at work.
The same holds true in the stock market. You can do as much research as you want into various companies to pick the right stock. Maybe you spend some time researching the strength of the CEO. Or perhaps you examine P/E ratios to determine if the stock is undervalued. You could also use or purchase the product, and buy that stock.
Then, the company’s oil tanker hits something in the gulf and the oil spills kills a bunch of birds. Or the company CFO (who you didn’t research) is caught in a scandal. Maybe a tornado rips through the company’s headquarters. Or the economy is down, and a new presidential election result causes a stocks value to plummet.
The truth is that you can do all the research you want, but life is unpredictable.
There are too many factors that can impact the value of a stock that you simply cannot know. And, remember, even people called Hedge Fund Managers who are paid to pick the best stocks outperform the market less than 10% of the time over a fifteen year period. Even when they are in the 5-10%, it is next to impossible to do it again.
Instead, we could be buying hundreds of companies through index funds placed in an appropriate asset allocation and not having to worry about which companies falter, because we know others will take their place.
3. A Home Run Isn’t Necessary
Picking individual stocks is a high-risk, high-reward situation. The adrenaline rush of picking stocks is the same emotional experience as gambling. It is the reason that people cannot help but check their stocks all the time when they are individual stock pickers.
What they don’t like to talk about is these stocks have an equal chance of being a home run as they do of striking out completely. In fact, they probably strike out more often than they go over the fence. Our love for competition prevents us from doing the right thing. The truth is that good investors understand it is a single player game like solitaire.
Fortunately, there is an alternative that will more confidently get us to our long-term goal. If the market average, taken over 15-30 years is enough to accomplish what we want, why play this game at all?
A personal story might illustrate the reason why.
Whenever my kids come up in conversation, the people that know me well ask if they play golf. It is not enough to say, “yes”. Instead, while I answer their question I usually pull out a video of my 7 year old’s golf swing, which looks better than mine. Then, I get to see the reaction others have when this tiny little girl (in the 10th percentile for her height) pound a golf ball 100 hundred yards down the fairway.
It is human nature to be proud. However, if my little girl was terrible at golf, I probably wouldn’t have shown a video of that. Why? Unfortunately, it is also human nature to more often share our wins than our losses.
This same phenomenon happens when people talk stocks.
When the conversation comes up, they can’t help but tell you about that one stock that they bought at $50 per share that is now at $125. What they don’t tell you about is the other ten stocks that they have that stayed the same, went down, or were only marginal winners.
Home runs aren’t necessary, but people love talking about them (while they ignore the record setting number of strike-outs).
4. You Don’t Have the Time
When I talk to other doctors about new opportunities, the most common thing I hear from them is that they don’t have the time. It’s often the truth. Our jobs and lives outside of the hospital keep us busy.
Yet, some of the busiest people I know pick individual stocks. This makes zero sense to me because doing the research and investigation into these companies to feel like you’ve “made a good pick” takes time. In fact, to do it well, it takes a lot of time.
Even then, you will still find some home runs and you will still strike out on many.
The investing approach that would better suit the busy doctor is a passive, set it and forget it investing method. This person should focus on earning additional money with their time and pouring more money into the market. If they stay the course, this is infinitely more useful than trying to pick individual stocks.
You should spend the minimum amount of time on your money that is necessary to be successful.
5. You aren’t Nostradamus
Patient’s often ask anesthesiologist to offer guarantees. “Promise me that I won’t die.” “Promise me that I won’t get a headache from that spinal thing.” “Please, don’t let me remember anything after surgery.”
While I reassure these patients appropriately, I also tell them something that I often heard from one of my favorite attending physicians in training. “Ma’am, if I could predict the future, I would probably be working in Las Vegas and not in Winston-Salem. I’m not Nostradamus, but we are going to take good care of you. That is what I can promise you.”
Despite the fact that we know that we cannot predict the future, that doesn’t stop people from acting like it. They claim to know it in their gut when the market is going down, or up. These people can predict the strength of certain stocks. They may not actually claim to be able to predict the future, but they sure do act like it.
Looking at history should teach us that this is a fruitless affair. Only 60 of the 500 companies found in the Fortune 500 in 1957 were still there fifty years later in 2017. This means that almost 90% of companies that were the 500 largest companies no longer held that classification 50 years later.
The opposite is also true. There were companies that didn’t even exist at that time who would one day become giants. Think about Apple, Google, Amazon, and Microsoft.
For this reason alone, it doesn’t make a ton of sense to predict which companies will still be highly successful thirty years later when you are selling the stock in your retirement. And, if you plan to sell it sooner, look back at reason number 4 (your time is highly valuable – don’t waste it figuring out which stocks to buy or sell).
Take Home: Should I invest in individual stocks?
Buying individual stocks is a loser’s game after we realize that there are a lot of things outside of our control and knowledge that prevent us from doing this well.
Why not invest in a broadly diversified index fund portfolio that takes the market average? If your savings rate is adequate, then the 6-10% you will earn on average in the market will be more than enough. And it will save you from all of the headaches mentioned above.
Should you invest in individual stocks? No. It isn’t necessary to hit a home run.
We can simply take our first attending paycheck, invest it index funds, and keep it simple the entire way through. Simplicity wins when it comes to investing and it saves you the time, money, and unnecessary stress that comes with picking individual stocks.
Do you invest in individual stocks? Have you found both successes and failures?
Has it consumed time? If you’ve done it for longer than fifteen or twenty years,
how does it compare to index funds over that time period? Leave a comment below.
Love the sports analogy.
If memory serves I think there were a few methodological errors in that hot hand paper. I think at the Sloan sports conference a few years later there was a follow up suggesting the hot hand may actually exist. I’d have to go digging to find the specifics.
TPP – how do you feel about owning Berkshire Hathaway? I know many index investors (some financial bloggers among them) who’ll make an exception for BH. Obviously a good strategy in hindsight but is there anything to suggest it’s a winning strategy in the future?
I’d love to see it, because it otherwise serves as a great metaphor for the stock market!
I have two thoughts on berkshire. As long as Buffet is alive, it is sort of like a “miniature” index fund. By that, I mean that Berkshire buys a bunch of pieces (And sometimes majority pieces) of different companies. It is also very tax-efficient for a taxable account.
My second thought is that I don’t know how much longer Buffet will be around, and I don’t know what I think of the person who will be following him. This portion seems a bit riskier to me.
I don’t lump Berkshire in with other individual stocks.
I once saw Cramer say the same thing talking to average investors on his show. He said most people should put no more than 5% of their money in such sticks, and keep the rest spread out. He then went on to tell you which ones to put it in, but that is another story.
For me, the small group of stocks I own inoculate the rest of my portfolio since I lose the temptation to want to do otherwise with those.
I do not include my ESPP holdings in that though. Do you agree with that?
That’s funny. You won’t find me plugging individual stocks 🙂 And, if you must invest in individual stocks, 5% seems reasonable.
As far as employee stock purchase plans, I’ve never had one. That said, my understanding is that you typically get them at a discounted price and then (if you hold on to them for a certain time period) that they can be sold or exchanged. I’d personally hold onto them for the length of time required, and then exchange them for index funds. I am sure that all of the Enron employees thought that they were getting a “Steal of a deal” too until they weren’t.
If people want to hold onto ESPP holdings, it shouldn’t make up for more than 5% of their portfolio, in my opinion.
The way my ESPP works is that you get the lower price of either the start or end of the quarter, and you get a 15% discount on that. That essentially pays the long term capitol gains for you. You can up up to 10% of your salary in it.
My current holdings are right about 5% of my net worth, and I actually had stopped adding to it in place of mutual funds; coincidentally.
Now that I think about it, in a rising market, I probably would benefit from adding to it, and taking the hit on selling the old shares that qualify for long term CG tax to keep me at 5%, and still get the quarter price difference benefit. I just realized that the company stock has gone up 50% in the last year, so oops. The problem is I am terrible at guessing the future, so that’s why I never did it in the past, after I got to about 5% some time ago.
When I first started investing and had not even heard of index funds I invested in individual stocks. And there was no rhyme or reason, just put money in companies I had heard of, didn’t know if overvalued/undervalued. etc.
I got lucky and hit it big on some stocks that more than made up for the ones I lost (bought amazon for around $200 and sold it (too early in hindsight) for $550).
But after the discovery of index I have pretty much put any money in that.
Everyone starts out thinking that individual stocks are how you should invest. I get that.
I just wonder about the people who find out about index funds and then continue to invest a large percentage in individual stocks.
I purchase individual stocks to tailor around my index fund for my own comfort and risk tolerance. I could be wrong, but here’s how I look at it: when I dollar cost average into an index fund every so often, I am purchasing a ton of securities at various weightings. Some of those weightings I don’t agree with. For example, I’d much rather allocate a higher proportion of my portfolio to Nestlé, which has a long track record of generating boring returns, than Facebook. I am much more comfortable with the probability that the core underlying economic engines of Nestlé or Johnson & Johnson or McCormick and Company (which all dominate their respective markets) will last longer than, say, Facebook. A typical index fund does not reflect this preference, so I tailor my own portfolio, which is largely indexed, with individual stock purchases in large cap, blue-chip companies that, in my opinion, are less risky, to help with the weightings in an index fund.
If you can do that well, you are a much smarter person than I am.
History teaches that we don’t know which companies will still be successful (or be around at all). I don’t know that we can predict one way or the other which way a company will go with any sort of consistency.
I do know that because I am human, I will always have an intuition one way or the other. Will it be right? Probably not.
TPP: here are the links
Cheers. Great points on BH. I know he’s trying to transition power to younger executives (the Amazon trade) but you’re right that Buffet won’t be around much longer and it’s questionable the company will run the same after he’s gone.