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Why Stock Picking is a Losing Investment Strategy

roulette

Picking a stock that goes up 100% in a year is exhilarating. But there’s a problem with this method of investing. Like gambling in Vegas, it may be fun and even rewarding in the short term. Yet in the end, just as the house always wins, picking stocks is a losing game.

I talk to friends all the time who say they invest in stocks — meaning individual ones rather than broad-based index funds that capture the movement of the entire market — and I always wonder why. I think many people see a company that carries a well-known name — maybe they are customers or they hear about it on the news — and they assume it’s a good investment. But history has shown us time and time again that picking stocks of individual companies, and thus trying to determine which will be the winners, is not a good investment strategy.

No company is immune to short- or long-term failure, no matter how good they look in the moment. The company’s value may not go to zero, but it could certainly take a huge hit relative to its underlying industry or index. Just think about how the Standard & Poor’s 500 index has changed in the past two decades. There has been a revolving door among the largest companies in the S&P 500, proving that even the biggest companies out there are not immune to volatility and risk.

Individual stocks vs. an index

As further evidence that picking stocks is risky and ultimately a losing game, consider recent research from financial firm JP Morgan Chase & Co. It compared the Russell 3000 index — which, as the company notes, “represents approximately 98% of the investable U.S. equity market” — between 1980 and 2014 with information on individual stocks. Here are the three main findings:

  1. The risk of ‘catastrophic’ failure among individual stocks is higher than you think. “When looking at how often a stock has what we call a ‘catastrophic decline’ — falling 70% or more and never recovering — we see that 40% of all stocks suffer this fate at some time in their history. And some sectors — like telecom, biotech and energy — saw higher-than-average loss rates,” the report states.
  2. Most stocks underperform over their lifetime. According to the report, “The data shows that two-thirds of all individual stocks underperform over their ‘lifetime,’ as compared to the Russell 3000. On average, the outcome for individual stocks was underperformance of about 50%.”
  3. Concentrated holdings in individual stocks add huge amounts of risk to your portfolio. “When computing the optimal risk-adjusted return for a concentrated holder,” the report notes, “we find that 75% of concentrated stockholders would benefit from some degree of diversification.”

Why investors keep picking stocks

So why do so many individuals keep trying to pick stocks? I see two main reasons.

We all enjoy making money, and we don’t usually associate the word “boring” with something we enjoy. That reason alone likely explains why so many people try to pick stocks. It’s the “sexy” way to invest. But the research is clear that this is not an optimal strategy. When it comes to investing, “sexy” might as well be spelled “sucker.”

Rather, investing should be boring. It’s like baseball: Base hits are the name of the game. By properly diversifying your investment portfolio — picking a mix of asset classes with exposure to many sectors and countries — with a long-term strategy, you allow yourself to take advantage of compounded gains without subjecting yourself to unnecessary risk (i.e., swinging for the fences).

The other major issue is that not all investors understand what they are doing. When you’re stock-picking, you may think that you are diversified by owning five different stocks; but if that’s all you own, you’re exposing yourself to a huge amount of risk by having such a large percentage of your portfolio invested in just one stock or industry. One catastrophic loss could devastate your portfolio.

Diversification

The logical question you might have is, “OK, so what should I do?” While answers are going to vary slightly for each individual, one applies across the board: Diversify. That doesn’t mean owning many different individual stocks in the same sector, but rather spreading your investments throughout multiple asset classes, industries and countries. Proper diversification of your portfolio is key to your investing success over the long run.

This article was originally published on NerdWallet.com

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The views expressed in this blog post are as of the date of the posting, and are subject to change based on market and other conditions. This blog contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Please note that nothing in this blog post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax or legal advice. If you would like investment, accounting, tax or legal advice, you should consult with your own financial advisors, accountants, or attorneys regarding your individual circumstances and needs. No advice may be rendered by Sherman Wealth unless a client service agreement is in place.
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Brad Sherman

About Brad Sherman

Brad Sherman has over a decade of experience in the financial services industry. He founded Sherman Wealth Management because he believes that every client deserves the highest level of individualized attention, regardless of their age or the size of their financial profile. He prides himself on being an advocate for his clients, providing a Fiduciary, fee-only service, designed to make clients feel comfortable with their investment choices and strategies. Brad lives in Rockville, Maryland, and enjoys football – both fantasy and real, baseball – especially his beloved Nats, and Nerf Ball with his young son.

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