Why The Average Investor Should Choose Index Funds Over Picking Individual Stocks
When it comes to picking stocks for a portfolio, the average investor is at a big disadvantage. Now I’m not talking about investing in mutual funds, which can have big ol’ expense ratios baked into them. I’m talking about good ‘old fashioned stock picking’, where you research companies, pick out which ones you like and invest in them. It doesn’t matter whether you invest through your retirement accounts or your personal investment portfolio, you’re still very unlikely to beat the returns of a diversified index fund.
I’ll be the first one to admit it’s not that sexy to be invested in Vanguard 500 Index Fund(VFINX). In fact, it sounds a lot cooler to tell your friends you own shares in Apple, Google and Facebook(well maybe you don’t want facebook) as opposed to a boring index fund. But there are some major drawbacks to picking out individual stocks that you may not realize.
Beating the Market
I had a friend at work come up to me and tell me how he’s “killin’ it” this year in his retirement portfolio, up 14%! He rattled off a few blue chip companies and overall I thought he actually did a pretty good job of picking individual stocks. There are much worse strategies that he could have employed. But then I did a quick check on the YTD return of the S&P 500 and as of 11/6/12 it was 15.63% while the return of VFINX was 15.48%. His return was over 1% less than the average return of the market and what he could have gotten with a low cost 500 index fund.
Personally, I don’t like to pick individual stocks because it’s not worth my time. My returns need to not only achieve the market average, but also surpass them to make it worthwhile. I know that I would be very thorough if I was going to pick stocks for my entire retirement portfolio. But it would only take me 30 seconds to invest in a low cost diversified index fund, while a ‘stock picker’ might spend 10-20 hours or more researching companies, reading through prospectus’, etc.
Better Than the Pros
Let’s say you don’t mind staying up late after work and researching companies until the wee hours of the night. Remember that when it comes to picking individual stocks, you’re competing against professionals. There are people that do this for a living and they spend 40-50 hours a week researching companies, reviewing financials and studying transactions. And the strange thing is even the professionals can’t consistently beat the market.
Do you know of any actively managed funds that have consistently beat the market over the past 10 years? There might be a handful, but what about the past 20 years? How about any active fund managers that tie their compensation to their fund’s performance, I sure don’t know of any. Take a look at this interesting analysis by Daniel Solin that showed how the big three US investment banks under-performed their benchmark average 65% of the time. That means that 65% of the time your fund was likely to return less than the market average.
Is it Ever ok to Pick Stocks?
Now that you know the proper benchmark to measure your returns against, what if you are successful at picking stocks? As I mentioned earlier, there are much worse strategies you could use than picking 5 solid blue chip companies. But with this blue chip strategy, your returns will most likely be close to the market’s average return. You’ll be very unlikely to exceed the benchmark by investing in safe companies because drastic and surprising growth is not likely to happen. If you are seeking above average returns, you have to be willing to take on above average risk and invest in up and coming companies that will exceed their projected growth.
I was actually lucky to start investing in a bear market because I had a relatively small amount of money and I lost most of it very quickly. It taught me a valuable lesson about picking individual stocks and today individual stocks make up only 5% of my total portfolio. I consider this portion more akin to gambling though and to constantly remind me how tough it is to pick winners.
Although online investment brokers have made it very inexpensive to invest in individual stocks, I still don’t think the risk-reward is worth it. Companies like Schwab and Vanguard are lowering their expense ratios all the time on their index funds to compete with one other. Unless someone is willing to share with me their guaranteed strategy for picking winners that will beat the average market returns I’ll probably stick with my boring index funds.
Readers, what percentage of your portfolio do you invest in individual stocks? Is there some added benefit to this strategy that I’m missing or do you just like to be in control of the funds you own?
-Harry @ PF Pro
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