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I RECENTLY READ an interesting article about why you shouldn’t pick individual stocks. The author mentioned the classic reason: “Since most people (even the professionals) can’t beat the index, you shouldn’t bother trying.”
He also mentioned another reason: “The existential dilemma of doing so… how do you know if you are good at picking individual stocks?” The author goes on to mention that, since luck plays such a significant factor in stock-picking, it could take a very long time to determine if you’re good or just lucky and, even then, you may never really know.
While these are both good reasons not to invest in individual stocks, it strikes me there are other reasons—nine of them, to be precise.
1. I’ve always been concerned that, when stock-pickers compare their results with an index, they may not know which index to use. I own a unique mix of master limited partnerships, individual stocks and mutual funds. I compare my results to the S&P 500. But since my portfolio is a little more value-oriented, maybe I should use the Russell 1000 Value Index. But I also own some foreign stocks, so maybe…. My concern about selecting the correct comparison index always seems to increase in years where I underperform the S&P 500.
2. Stock-pickers have to deal with buyouts and reorganizations, which then trigger capital gains. This plays havoc with tax planning and possibly with income planning. A few years back, a very significant position of mine, Kinder Morgan Partners, was reorganized from a master limited partnership to a corporation, sticking me with hefty unplanned capital gains. It didn’t help when the company subsequently cut its dividend, which led to a precipitous decrease in its stock price. Who likes to pay tax on capital gains, only to see the value of your current position is worth less than the capital gain you’re getting taxed on?
3. Brokerage firms can misclassify a stock’s dividends. The first page of a 1099 sums and classifies all the dividends, distributions, interest and so on. But what if it’s incorrect? I generally review my 1099’s details to see if there are any noticeable issues, but I certainly don’t go through it with a fine tooth comb. This year, I noticed my dividend amount was much higher than last year’s. It turns out that E*Trade incorrectly classified a tax-free spinoff of shares of Brookfield Renewable Partners as taxable. I’ve been “discussing” this with them for more than a month. Wish me luck.
4. Reporting each individual stock’s capital gains after a sale, buyout, special dividend and so on can be time consuming. Tax software may help with this issue, but you still need to verify the numbers (see No. 3). Also, prior spinoffs, returns of capital and multiple purchases can make determining the cost basis quite complicated. In 2011, brokerage firms started reporting cost basis, which is helpful. But if your stock has had multiple spinoffs or mergers, checking your brokerage firm’s math can be difficult.
5. A stock-picker who invests in foreign stocks will have to pay foreign taxes. He may then think, “Well, I’ll just claim a foreign-tax credit and everything will be jake.” Well, it may be—or may not.
6. If you own individual stocks, you can look forward to an avalanche of proxies. Each company states that “your vote is important” and offers the stock-picker the illusion of having a say in how “your” company is run. In reality, the amount of “your” say is vastly overstated, plus “your” company generally doesn’t have to abide by the results of “your” votes. Directors are reelected with less than a majority, and advisory votes on compensation are ignored. While your vote in public elections always counts, in corporate “elections” it’s much less so.
By sticking with mutual funds, you can avoid the hassle, the waste of time and the guilt. I take my shareholder responsibilities more lightly with every passing year and, now that I’m retired, I can’t be bothered, though I always vote for independent chairpersons. Note: I voted against ExxonMobil management in this year’s proxy fight, which culminates with today’s annual meeting. As my mother used to say, “Hope springs eternal.”
7. If you own individual stocks and have beaten the index (see No. 1), you may now believe yourself to be an above-average investor. This may tempt you to use your individual stocks to write options. If you haven’t done so well, you may still be tempted. Mutual fund owners do not have this temptation.
For example, you underperform the index for a few years and think you can make up some of this shortfall by writing call options on your shares of, say, Walt Disney Co. But then Disney has an unexpectedly good quarter and your shares get called away, leading to unforeseen capital gains (see No. 2). You also then miss out on the subsequent share price increase. Then COVID-19 hits and Disney shares drop significantly, and you start feeling pretty good about your investing acumen—for a little while. Then Disney subsequently comes roaring back and then some, without you on board. Note: This is all hypothetical.
8. Some stock-pickers try to use their picks to generate a certain amount of income, an amount they feel they “need” from their portfolio. These folks tend to hew toward higher-yielding stocks. Common sense, corporate finance and tax regulations all argue that yield shouldn’t be a factor in selecting stocks. By focusing on yield, stock-pickers unnecessarily limit the stocks they might own, which can’t be a good thing. What if you need more income from your investments? Taking some capital gains, by selling a small portion of your portfolio, is the best way to accomplish this. It will also allow you to better time your capital gains to assist with tax planning (see No. 2).
9. Unless a stock-picker has the stomach of a jet pilot and the discipline of a Spartan warrior, buying individual stocks on a regular basis is almost impossible. When the stock market is setting record highs, you won’t invest, as you’ll think, “How can the market get any higher?” When the market is setting new lows, you won’t invest, as you’ll think, “What if things get really ugly?” Setting up automatic investment plans, where you invest regularly in low-cost mutual funds, will allow you to bypass such questions and the associated stress, while providing the added benefit of dollar-cost averaging.
By now, you may be thinking, “Okay, we get it, enough already. It sounds like you’re trying to convince yourself.” And you would be correct. The observant reader will have noticed I still own some individual stocks and ask, “Why don’t I take my own advice?” I’m trying. I’ve reduced my holdings in individual stocks. But in the words of the long-term smoker who’s trying to quit, “It’s tougher than you think.”
Michael Flack blogs at AfterActionReport.info. He’s a former naval officer and 20-year veteran of the oil and gas industry. Now retired, Mike enjoys traveling, blogging and spreadsheets. Check out his earlier articles.
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If your goal is to never get rich, mutual funds are great. You’ll get floated along at the same level with every other boat. But if you goal is to make a bunch of money, you need to adopt the same strategy used by Hollywood Movie Studios – make some bets, take some risks and look for winners with long tails. If you were smart or lucky, you got AAPL, AMZN, GOOG, MA, CRM, AMGN, etc 10 or 20 years ago and didn’t sell. Owning individual stocks is a GREAT strategy of you have a long horizon and ditch your losers before it’s too late..
Thanks Brett Howser! I’ve heard of growth investing, value investing, and dividend investing, but not Hollywood Movie Studio investing. Sounds foolproof, but I think I’ll go with Purple Rain’s 8% per year (see below).
Investing in individual stocks is not wrong, in my opinion. However, all the challenges you address need to be addressed, cheerfully and persistently. As you point out, this is hard work with no clear reward.
Why do I do it, then? I do it because I believe I can approximate the same return with investments that are of fundamental higher quality. Of course, I am not always right, and GE is a perfect example. One of my principles is that I do not invest in companies where I know the management is lying or cheating. That means when I find out, I need to replace that position, assuming there’s anything left.
I believe, as I age, I will need to stop selecting stocks, even though sometimes, like the present, but not like last year, my long term return slightly exceeds that of the S&P 500. But will I know when that time comes?
Does anyone else commenting believe that selecting stocks can allow the disciplined investor to strike a better balance between risk and yield?
>> I do not invest in companies where I know the management is lying or cheating.
I don’t invest in companies where I can’t know whether the management is lying or cheating. That would be all conglomerates, by definition! On that basis, investing in GE made no sense whatever for individual investors for decades before it crashed.
Steve Spinella, Thank you for your comment and as a fellow GE shareholder . . . I feel your pain. Interesting idea, though I think outperforming the market when it comes to risk is as difficult as outperforming the market when it comes to return. It may be possible, though you’ll never know if it’s due to luck. Also measuring return is quite easy, I’m not sure if you can accurately measure risk.
I’ve also tried to get an administrator to correct a reporting error–but eventually I realized there were a couple reasons they never would. First, someone would have to tell a smarter, higher paid coworker or a computer that they had made an error. Second, acknowledging this was an error in any way would require issuing corrections to everyone affected, work that does not result in any profit for the company.
I ended up reporting what I thought I knew to be correct, but showing it as a correction on the tax return. That way the IRS’s computers could be happy, but if a person were by some odd chance to review my return, they would see why I made the adjustment. Then the reasoning above sort of, kind of works in my favor, instead of me fighting it.
Steve Spinella, thank you for your comment. I was successful in getting E*Trade to correct the error and send out a revised 1099, though I had to spoon-feed them and connect them with IR at Brookfield. Like investing returns, it all may have been luck.
“though I always vote for independent chairpersons”
Independents usually have an (liberal) agenda that does not consider the best interests of the shareholders, from green to “workers rights” or some other cause that will reduce profit.
corrupt, thanks for the comment. Interesting. Please share any studies that confirm your hypothesis. If you do not have any, then please share any anecdotal information.
I also invest solely in individual stocks; however, I use active bond funds for that part of my portfolio.
I find it works better for me to select my investments one at a time rather than to invest in the market as whole. This way I don’t worry about the stock market, but try to focus on the underlying business performance of my investments.
I try to follow the Warren Buffett approach. Hence, my benchmark has been Berkshire and the S&P 500 because that is the benchmark that he uses.
100% of my investments are in a traditional IRA so tax is not an issue and my explicit investment costs are essentially zero. However, there is an added cost of owning foreign dividend paying stocks in a tax deferred account.
Thanks for the interesting post. I was also glad to see that I’m not the only heretic reading these pages.
Best to all.
Richard Gore, thanks for the reply. Not sure using Berkshire as a benchmark is correct, as it is not so much a mutual fund, but an insurance company that invests in a diverse array of small companies and large-cap publically traded stocks. Also, I’m not sure if I could outperform a man who lives and breathes stock investing.
I am a value investor who refuses to invest in ridiculously overpriced indices. I invest solely in. dividend growth stocks that are fairly valued or undervalued.
I earn enough in dividends to cover my annual expenses. I don’t plan to ever sell. While the market fluctuates (sometimes wildly), my divvies are steady and growing at the rate of 8% a year.
Purple Rain, An 8% yearly growth rate is impressive as it would double the amount of dividends you’re receiving every nine years. Wow!
I have been an individual-stock investor all my life – never owned a mutual fund. Right now I have about 60 different securities.
The author is correct in saying that investing in stocks isn’t easy. You have to understand corporate finance, you have to read the footnotes in 10K reports, you have to study quarterly earnings conference call transcripts.
Since I don’t believe ‘the market’ exists, I don’t propose to ‘beat the market’. I just want to suit my own needs with a portfolio of companies that provide an appropriate level of risk for my situation, and a decent income.
>> Since I don’t believe ‘the market’ exists, I don’t propose to ‘beat the market’. I just want to suit my own needs …
This. Moreover, early in my investment career I also realized that ‘the economy’ doesn’t exist. Some companies are highly profitable no matter how the overall economy (a fiction based on select generalities) is doing. People say “ah, but they’ll be affected” by economic events. Of course, but if they’re affected less so than the others that’s what matters. It’s all relative.
Ormode, I like that way you think! This theory could come in very handy the next time I lose a game of chess.
Thanks for the perspective Michael. I’ve been doing this investing thing for a lot of years now, and it’s still hard for me to believe and accept that successful investing can be as simple as buying a few index funds, and then (mostly) forgetting about it. Could it *really* be this easy? I’ve decided that for most of us, the answer is a resounding “yes!” Although, for some, as your narrative attests, it’s not quite that easy, lol.
Take heart though. as with many other areas of our lives, “sinning” a little every now and then isn’t what will ultimately derail a successful plan. Eating a few M&M’s, drinking the occasional glass of wine, or overdoing it at the odd picnic isn’t going to make us overweight, or saddle us with high blood pressure and heart disease. In fact, I would argue that allowing ourselves these occasional indulgences helps keep us better focused and on track (with special emphasis on the word “occasional”)..
I’m sure you’ve figured this out long ago; using a small fraction of our portfolios to pick a few stocks can be fun for some people, as they enjoy the thrill of the chase. And that’s fine, so long as they keep the guard rails around the bulk of their assets (to protect it from themselves!) and keep their serious money separated from their play money. As the old cliché says, “all work and no play…” well, you know.
wtfwjtd, I wish my indulgences were only occasional!
“Never confuse a genius with a bull market”…unknown.
Mik Cajon, thanks for the comment.