We all know the market has been on a tear the past couple years. The S&P 500 is at an all-time high and I know my 401(k), along with others’, has performed tremendously well. But my awesome returns aren’t due to the fact that I’m an investing genius, all I’ve done is maintain my portfolio with a few low cost index funds and that’s it. I’m sure there are others who go the opposite route and pick a handful of individual companies and they’ve probably seen awesome returns too.
But is all the money this second group makes due to their extraordinary stock picking talents or is it due to a positive market trend in general? I tend to believe the latter since any gain is a good gain in most people’s books. I don’t think the key to investing lies in stock picking, instead I think it’s about being consistent and sticking to your investment plan. If your asset allocation is 90/10 during good times, it shouldn’t change during bad times.
Don’t get too used to 10%+ annual returns since they could disappear at any time. Although the market has averaged a 10% annual return since it’s inception there have been years of -20 and even -30% returns. Now that we’re in a bull market, it’s actually a good time to look at your retirement accounts and re-balance if necessary. If your AA has skewed toward stocks, then you’re going to want to sell some of those stocks and rebalance with more bonds.
Comparing Your Returns
Even actively managed investment funds are performing well in these times. But how well depends on what benchmark you compare them to. Benchmarking is the process of comparing one’s returns to industry standards. In this case, if I’m investing in a variety of hand-picked stocks like an actively managed fund would, I need to compare the returns to a benchmark like the total market index.
In another scenario, let’s say I’m invested in an S&P 500 index fund through my IRA account and it’s returned 12% YTD. 12% sounds great doesn’t it? The only problem with that number is that the S&P 500 benchmark has returned 14% this year. By investing in a Vanguard 500 fund like VFINX(with a low expense ratio) you could have actually exceeded the benchmark’s return. Discrepancies like this are normally caused by high expense ratios or active managers trying to pick and choose and guessing wrong so be sure you understand what funds you’re invested in.
Stock Picking is For Suckers
If you like to engage in stock picking, where you only invest in a few to a handful of companies, you are taking on uncompensated risk. One of the core tenets of investing says that if you take on more risk you should be rewarded with higher returns. That’s why we invest in stocks more heavily than bonds when we’re young. But by investing in only a few companies, you are increasing your expected risk while your expected return stays the same. There’s nothing that mathematically indicates you will achieve a higher return by investing in only a few companies. You can easily eliminate this risk by investing in a diversified fund of companies like an index fund.
The reason why I bring this up is that in a bull market, uncompensated risk is sometimes not as apparent as in a bear market. Since nearly every stock is trending upwards, no matter what company you select, you’re probably going to make a lot of money so you forget about the risk that you’re taking on. Once the market turns bear, there’s a higher chance that one of your individual stocks could go bust and devastate your returns accordingly.
I still think a simple three fund portfolio or even a target date fund(with low expense ratios) makes the most sense for 90% of investors. Investing doesn’t have to be that complicated, but when you start investing in individual companies and employing complex strategies, things can get confusing. I would never invest in anything I didn’t fully understand since the risk is not worth the reward.
Readers, do you understand the concept of uncompensated risk and why it makes no sense to invest in an individual stock?
-Harry @ PF Pro
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