The Danger of Picking Stocks

Investing in the stock market by selecting a handful of individual stocks is tempting for many investors who dream of making substantial gains by picking the next big thing. Despite the allure, there are many compelling reasons why investors should think twice before diving into individual stock picking and market speculation.

Do you ever find yourself buying or maybe asking your financial advisor to buy stocks that you believe are going to get you the best future returns but then second guess whether or not you should hold or sell those stocks after they go up or down significantly in price? If so, this is totally normal. This psychological phenomenon is one of the main reasons stock prices are so random and helps explain why self-selecting a handful of stocks can be a dangerous proposition to your financial future.

Hi. I'm Cameron Valadez, host of the Retired-ish podcast. And today, we are going to have a down to earth chat about investors, especially those saving and investing for retirement, trying to pick and invest in individual stocks. I certainly have my own opinions on this particular investment approach, but rather than push my own opinion on you, I want to talk more about the different reasons why it might be dangerous to you and your family's financial future to do so.

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I'm a financial planner at heart, not a proclaimed professional stock picker. So, during my day today, I am more so focused on preserving and or growing my clients' nest eggs, which means not letting them add undue risk to their financial plans. So that should kind of give you a hint on where I lean on this topic. But if you are a DIY, do-it-yourself investor and find yourself experimenting with picking investments for whatever reason, I first want you to ask yourself, why am I deciding to take this approach? Why am I doing this? And what is my end goal? Are you admitting that you're picking stocks based on a hunch and you're hoping that you might just get lucky, therefore, you are willingly speculating and going to pursue the route of actively trading and timing the markets? Or are you simply confident enough in your abilities that you can do better over the long run than those who are deemed “professional” investors?

Professional investors and financial analysts spend their entire careers and much of their free time studying the stock market, analyzing financial statements for individual companies, and staying updated twenty-four seven on market trends and economic indicators. The typical investor, however, or nonprofessional, often lacks the time, resources, and expertise to conduct the same level of thorough research. Without access to the same level of information and the ability to interpret it accurately, the typical investor is at a huge disadvantage. Numerous studies have shown that the majority of stock market investors underperform the various market benchmarks, such as the S&P500 index, as one example. Even “professional” managers or mutual fund managers equipped with advanced tools and resources often struggle to beat the market consistently.

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For the average investor, the odds are even lower due to the reasons I just mentioned. And by attempting to pick individual stocks, they often miss out on the average returns that a properly diversified portfolio might provide. That being said, let's take a look at what the research says. First and foremost, there is virtually no consistent research that picking individual stocks leads to superior performance than the overall stock market, not by the average investor nor the “professionals.” And when I say professionals, I generally mean professional money managers at places like mutual fund companies that manage the mutual funds. They're analysts, day traders, the investment teams that run endowment funds and pension funds, hedge fund managers, and even financial advisors who like to stock pick for clients. On the flip side, there are countless studies that show that most active traders or stock pickers underperform the markets in the long term. And I really hate to cherry-pick any particular study here, but there is one that I think at least sums up the biggest issues with individual stock picking, which has to do with our own investing behaviors and psychology.

And that is the study called Stock Price Predictability and the Implied Cost of Capital by Benartzi, Thaler, and others in 2001. This study addresses the predictability of stock prices and how investors' own behavior, biases, and expectations influence the implied cost of capital. And again, the investor in this situation could be you or maybe the “professional” picking individual stocks for you. We are all human, and we are all subject to these behavioral biases or biases. I don't know how to say it. Here is a brief synopsis of the paper. The paper aims to investigate two main questions. And the first question has to do with stock price predictability, and that is, can stock prices be predicted in a meaningful way? Can investors use past stock prices or other market information to forecast future returns? And this ties into the broader question of whether markets are efficient as predicted by much of the traditional finance theory that is out there.

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And the second question has to do with the implied cost of capital. And the paper examines the concept of the implied cost of capital, which they refer to as the rate of return that investors expect to earn on their investments in stocks. This rate is important because it serves as a benchmark for the pricing of stocks and the performance of individual stocks relative to the market expectations. And here's what they found. Behavioral finance studies show that individuals are subject to biases such as overconfidence, loss aversion, and what we call herd behavior, which can lead to the mispricing of stocks. And as a result, stock picking may not be a reliable strategy for long term outperformance. Individual investors who try to pick stocks are subject to these biases, which make it difficult for them to consistently beat the market. Overconfident investors may believe they can beat the market, but their decisions to buy and sell stocks are often influenced by irrational emotions and cognitive biases rather than any sort of sound analysis.

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The key takeaway from this research is that stock prices are not entirely predictable based on the fundamentals of the companies alone. They are also influenced by investor psychology, including the biases I just mentioned, like overconfidence, loss aversion, and herd behavior. These biases lead to predictable patterns in stock prices, which suggests that markets are not fully efficient as traditional finance theory assumes. Now, the study also highlights that the implied cost of capital that I mentioned earlier, which reflects investors' expectations about future returns, is shaped not just by company fundamentals but also by these psychological factors. Therefore, stock picking can be a losing proposition for many investors since their decisions are influenced by biases that distort their judgment and can lead to poor long-term performance. This isn't saying that all stock picking can't work because, of course, investors can get lucky, and sometimes they do. But the likelihood of being a consistently successful stock picker is very low. So, let's dive a bit further into some other research that might help you make more sense of this.

Jason Zweig, in a Wall Street Journal article, also cited research which noted that less than half of all stocks ever generate positive returns over their publicly traded lifetimes. Less than half. This means that the majority of individual stocks end up underperforming relative to their initial price or fail to provide investors with any long-term wealth creation. That is an incredible statistic, given the fact that there are thousands of publicly traded companies, many of which look to be wildly successful from the outside in our day-to-day lives. For example, many of the brand-name things you buy, consume, enjoy, and see all around you every day may seem like very big and successful businesses. But still, the majority of these companies don't actually account for any wealth creation for investors in the long run. This is part of what makes investing so hard.

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It's not always as simple as, hey, I'll just buy stock in the companies whose products I see people using and consuming every day. The article also emphasizes a particularly important statistic that stands out even more so to me, and that is that only around 4.3% of stocks accounted for all of the net gains in The U.S. stock market between 1926 and 2016. That's only around 4% of stocks over ninety years. This means that just a handful of companies, a tiny percentage of the total number of publicly traded companies, were responsible for the majority of the overall market's growth during this ninety-year period. This is an entire lifetime for an investor.

Now, what's even more interesting is that if you were to cherry-pick a particular time frame within that same ninety years and compare it to another, the stocks providing the most gains are likely very different during each period. For example, if you were to look at, say, the five-year period of 1982 through 1986 and compare it to, say, 1999 through 2003, the companies dominating the markets during each of those time periods were likely very different. If you don't believe me, just look at how drastically the 30 companies included in the Dow Jones Industrial Average have changed over time.

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So, the very small subset of companies that did end up accounting for most of the growth over the full ninety years may or may not have been the most dominant companies at any one particular time. In other words, the 4% of companies didn't necessarily lead the markets through the entire ninety-year period from start to finish. And we can see similar results with even more recent data.
Another remarkable research paper by a gentleman named Hendrik Bessembinder called Long Term Evidence from 64,000 Stocks shows that from 1990 to 2020, only around 2% of all U.S. stocks created all of the value in The U.S. stock market, and about 1.5% of all global stocks created the value of the global stock market. And of The U.S. stocks alone, just a handful were worth 14% of all of the shareholder wealth created during that time. That's a scary thought. Right? What if you didn't own any of those companies throughout that entire time period, or maybe only one or two? When stock picking or attempting to timely buy and sell certain stocks, it's incredibly easy to fail to capture these returns. Why is that? Well, let's say you happen to own one or more of the would-be-great companies of your personal investing lifetime, and they end up not generating much of any return or even go down in value over just a couple of years after you bought them.

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In other words, the short term, while other stocks go up significantly during that same time. Therefore, you then sell them. Then, after you sell them and buy some other investment or leave your money in cash, the stocks you just sold end up producing most of the overall market's return for over a decade to come. In other words, the long term. See the problem here? This would be very easy to do since we as humans tend to think in the shorter term and react to our own emotions and psychological biases and don't have the luxury of knowing what's ahead. Now the flip side of this can happen as well, where you may own companies that do phenomenally over a small number of years. So you continue to hold them, assuming you made the right investment decisions.

But then, over the long term, they end up being poor investments because they slowly decline in value over time, their price suddenly collapses and never returns to where it once was, or it simply just doesn't generate much in positive returns going forward. It's a difficult game. And if you go down this path, you might find yourself continuing to jump around between investments because they don't work out how you thought they would in the time frame that you expected.

And therefore, you end up not giving anything the time it deserves to actually perform. When investing on a hunch and buying concentrated stock positions, you also won't usually see the average returns that you normally hear about with the overall stock market in real-time. Most of the time, it's likely that your handful of individual stock picks will either be up substantially or down substantially compared to the averages or go nowhere at all for long periods of time. And this issue right here can be very impactful on your financial livelihood when living off of your investments due to what we call sequence of returns risk. This is a risk we have discussed many times in previous episodes.

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Another interesting fact is that in the year 2019, there were only 52 companies in the Fortune 500 that had been there since 1955 and had remained on that list the entire time. The other 90% of companies either went bankrupt, merged with another company, were acquired, or shrank so much that they fell off the Fortune 500 list.
The overwhelming point I'm trying to make is that the overall market returns that investors typically expect are largely driven by a few standout companies over long periods of time, such as a twenty to thirty-year retirement, while the performance of the rest of the market may be lackluster or even negative. The biggest risk here is obviously the fact that by concentrating investments in individual stocks, you're exposed to the possibility that many of your particular picks will not be among the small percentage of companies that may drive the majority of market gains moving forward. This is why proper diversification, even if you're diversifying amongst only stocks, is so crucial in mitigating risks to your financial plan. By not diversifying appropriately, you face the challenge of having to consistently pick the rare winners while also avoiding numerous losers. We don't get to know which companies will dominate during the next ten, twenty, or thirty years. But, in fact, that doesn't even necessarily matter.

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The only specific time frame that should matter to you is the one that aligns with the goal you are saving for. Retirement being only one example. Now, let's talk more about how our emotions make investing on our own even more difficult. Investing yourself in choosing stocks or even choosing certain mutual funds or ETF products introduces what I would call execution risk, which is a fancy way of explaining when to buy and sell and the emotional decision-making since it's your money. Ultimately, the larger your bucket of money becomes, the longer it takes to save that bucket of money, or the more meaningful the particular amount of money you have is on your livelihood, the more emotional your future decisions will become, which is not a good thing when it comes to investing.

For instance, when you started your investment journey to save for retirement, you may not have cared too much about whether or not the investments you chose performed extremely well since you were just starting and didn't have much skin in the game, and the thought of retirement, what it would be like, what it would cost, and what your situation might be at the time was so far off into the future, it was basically incomprehensible. But as time flew by and decades later, you began to consider leaving the workforce, and you've socked away decades of savings, you started to pay a little more attention to what can happen to that money and how you will be able to use it and enjoy the fruits of your labor without running out, especially since you may not be saving any more money at all, only spending it. As you can see, it only makes sense that our emotions will be incredibly heightened during this stage of our lives.

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When you add the risk of these emotional aspects of investing to the risks of being under-diversified, you increase the risk of putting your financial livelihood on a tightrope.

I'll leave you with this. The fewer the individual companies or stocks you invest in, the more chambers you have in a game of Russian roulette, and there's a bullet in one of them. And if a majority of your net worth is invested in just one stock or particular asset, like in the case of owning a ton of your employer stock, you have an unlimited number of chambers. Each day that goes by that you're relying on that one stock or single asset, you're pulling the trigger. And it doesn't matter how many times the hammer drops on an empty chamber because one day, it will come down on the one with a bullet in it. The most relevant question you should be asking yourself if you tend to be a stock picker, market timer, or active trader with your investments is this. What would be the effect on my family and me if my stock picks fail with the money I have invested?

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Here's a mental exercise to help with that. If you were to take the total value of the one or a handful of stocks and completely delete it from your financial plan as if that money never existed today, what would that look like? And if you don't like what it looks like, you should strongly consider changing your strategy. In fact, even if the value were to stay the same rather than losing it all and not being there, and it did not grow at all for the rest of your life, what would that look like?

Now, of course, one might argue, well, what if my stocks do the opposite and continue to grow significantly into the future and build wealth beyond my wildest dreams? What could that do for my family? And my answer to that would be that you don't make the decision to start diversifying based on the future prospects of the particular stock or company. Because as we discussed, there is no real way of knowing what that company stock will do over your goal's particular time frame. Instead, you would make the decision to diversify solely to reduce your family's risk profile. So, if the stocks continue to go up after you begin selling them and diversifying away, it doesn't mean you were wrong to do so. And it makes no sense to fall in love with a stock or a handful of stocks because the stock will never love you back. Love means never having to say you're undiversified. And as I like to say in practice, we will never own enough of any one idea to make a killing in it, and we will never own enough of any one idea to get killed by it.

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When investing your hard-earned savings for an important goal such as retirement, you don't want to skip out on the opportunity to invest in an efficient wealth-building machine, such as the U.S. and global stock markets, by instead turning your portfolio into a casino and speculating if you don't have to. Why reduce your probability of success for such an important goal that is largely based on time, which you have a limited amount of? If you don't consistently win in the casino over many years, you may not have enough time to reach your long-term goal. Patience and persistence are key.

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Thanks again for tuning in and following along. See you next time on Retired-ish.

Disclosure [00:23:22]:
Cameron Valadez is a registered representative with, and securities and advisory services are offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC.

The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

All investing involves risk, including loss of principal. No strategy assures success or protects against loss.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.