Stock Picking v. Indexing.

Individual stock picking is exciting and the thrill of selecting a winning stock is exhilarating.  Investors are constantly searching for the next big winner hoping to find another Amazon.  Stock pickers try to outperform the market, usually the S&P 500, by buying winners and ignoring losers.  The top ten stocks in the S&P 500 this year are up 67% while the bottom ten are down 41%.  How do you find the best stocks?

I’ve found most investors primarily focus on large companies with brand name appeal like Apple, McDonalds and Boeing and ignore other sectors such as small companies or international investments.  Investors also tend to overload on stocks in their own backyard so individuals who live in Houston are likely to own shares in Exxon.

Trying to pick stocks to outperform the S&P 500 Index is futile because in a diversified portfolio you may only have 25% exposure to companies in the S&P 500.  In a million-dollar account with 60% invested in stocks and 40% in bonds, the large cap holdings will account for 25% of the entire portfolio.  With $250,000 to invest you can allocate $25,000 to ten stocks.   Morningstar currently tracks over 20,000 companies so how do you pick the ten best?  If you limit your search to the S&P 500, you’d have to identify the top 2% of this index to find your ten stocks.

To create more diversification in your portfolio, you need to add more stocks.  As you add more stocks, your account starts to resemble an index fund.  A study by Dimensional Fund Advisors found that if you own 50 stocks, your probability of outperforming the stock market on a one-year basis is 56%.   Over a ten-year period, the probability of outperforming the market is 69%.   How many stocks do you need to own to get close to outperforming the market?  The answer is 1,000![1]

Most investors don’t have the financial resources to own 1,000 stocks nor do they have the time to follow and research each individual company.   Jim Cramer says you need to dedicate an hour each week to each position to fully grasp the stocks you own.[2]   If you own 1,000 companies, you need to allocate 1,000 hours to study your holdings and a week only has 168 hours so you can do the math.

A better alternative for your investment portfolio, is to purchase a basket of index funds based on your financial goals.  Your financial goals will help determine your asset allocation and investment selection.   Instead of spending thousands of hours on stock research, devote your time and effort to refining your goals.

Teach us to number our days, that we may gain a heart of wisdom. ~ Psalm 90:12.

Bill Parrott is the President and CEO of Parrott Wealth Management, LLC.  If you want more information on financial planning and investment management, please visit www.parrottwealth.com.

August 19, 2017

 

[1] Dimensional Fund Advisors, The Importance of Diversification, June 1979 to June 2016.

[2] https://www.thestreet.com/static/rules6.html

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