Stock Picking vs Index Funds: Is Stock Picking Ever Rational?

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Consider something for a moment.  If you stock pick (individual stocks) rather than buying funds, you have an 80%+ chance of not beating the market over a 5 year period. That goes down to about 98%+ over a 40 year + investment career.  There are many reasons for this. 

Even small costs of buying and selling build up.  Good short-term returns, moreover, increase egos, and complacency comes into play. One of the biggest reasons is that the information is all there transparently, so there is no such thing as a free lunch. Remember, all the information about companies is publicly available and there are people whose job it is to look at this information and weight the pros and cons of all that information.

Take tech as an example.  It was true in the 1990s that those IT geeks who correctly predicted the future, could have made tones of money. Certainly early investors in Facebook or Amazon did.  However, it would have been madness to put a significant percentage of your wealth in Amazon in 1995. A rational investor can only make decisions based on the information he or she has available at the time.  Predicting the future is almost impossible and those who get it right once, probably won’t next time. This is something cryptocurrency advocates should know too well, considering many believed in hyperinflation and a depression as bad as the Great Depression 5-10 years ago. 

There are so many unknown unknowns and know unknowns for all companies, and especially start-ups. If Amazon’s CEO would have died 20 years ago, or there would have been a huge scandal or employees would have joined a competitor on mass, the company would never have succeeded.  Who knows, maybe Amazon almost went bust early on before they publicly revealed information which only becomes a legal requirement once it goes public.  And more to the point, even though tech has on average done well over the last 20 years, most tech firms have gone bankrupt. 

Buying the market and a broad basket of companies isn’t speculating.  It is just assuming that, like always, in the long-term, the biggest 100-200-300 companies in the US or elsewhere will be worth more money in 10-20-30 years than today.  So regardless of whether in 2050 most of the S&P is financial services, law, consumer goods or even bitcoin mining companies (i doubt that though!), an investor who buys the market will profit.  They just won’t profit as much as somebody who invests 100% of their wealth in the one coin that beats the market!  One of the reasons the average DIY investors only makes on average 4%-5% per year when markets have gone up (historic average) 10% per year, is because they assume they are smarter than others due to `research`.  

It is human nature to think you are smarter than the average, but the academic evidence is clear that enhanced knowledge won’t allow you to consistently beat average market returns.  You will almost certainly beat the market some years, but on average, you will lose long-term.

This whole mania around cryptocurrency is another case in point.  The price could go up or down, but very few people (or any) are buying `a basket of coins` which tracks the average price of the market.  Instead they tend to buy 1, 2 or a maximum of 3 coins. This means, that even if the market increases in the future, many people in the market are engaging in something akin to stock picking.  

Let’s say somebody owns one coin, and that coin is implicated a political scandal after a dictator stashes and it is subsequently outlawed across numerous countries, then the price will go down.  Not to mention, let us imagine for a second the coins become a victim of their own success, they do become a threat to the state’s ability to raise revenue, and therefore becomes a libertarian’s dream.  State regulation will hammer the price.  I have heard some people say the ridiculous phrase that `regulation can’t affect the price`.  That is silly.  Let’s give an extreme example now.  Let’s say in 2019 there is a terrorist attack funded by some of the coins, as terrorists use it to fund themselves.  If there is a popular backlash and the coins are banned globally or even just in the OECD, the price could go close to $0.  Every time a new regulation is announced, the price goes down.  It could be made an illegal offence to own or trade any coin tomorrow or the day after tomorrow, in an extreme event.

The price of bitcoin and other coins may skyrocket, but that doesn’t mean that an investor is irrational to say no to it in 2018.  It is pure speculation and at best should represent 5% of a portfolio if somebody can’t resist the temptation.

One Reply to “Stock Picking vs Index Funds: Is Stock Picking Ever Rational?”

  1. Worth staying that Crypto currencies have come back to ground (loosing 50%+) since this article was written. Adam advise is still very sound that individual stocks or bitcoins don’t beat the market consistently. Stay with Index funds, and get rich slowly!

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