In the long term, the stock market always goes up. In general, you would do well to put all your money into an S&P 500 index fund and just let it run until retirement.
That said, is picking individual stocks worth it?
Many people, including myself, subscribe to financial newsletters for stock picking advice. It’s a very tempting thing to do. Financial newsletters often tout outperformance of the market with their stock picks. In a way, buying financial newsletters is like outsourcing stock analysis. You no longer have to keep an eye on the market and analyze stocks yourself. You can pay professionals to do it for you. For busy people, that sounds like a win-win situation. They make money, and you make money.
However, there are a few big ugly truths about the financial newsletter industry.
1) Survivorship bias: Some financial newsletter companies test out dozens or hundreds of portfolios before releasing a new newsletter. Most of these lose money, but a handful might outperform the market. The newsletter company would then cherry pick the most successful of their test portfolios and market them touting their past returns. But nothing lasts forever, including stock market returns. Often, these new newsletters would go on to underperform the market after everyone buys in.
2) Underperformance: About 90% of professional stock pickers fail to beat the market over the long term.
3) Lack of transparency: Very few financial newsletters would ever show you their overall returns compared to the overall market. If they did, you would quickly see that you would be better served just buying an index fund than buying their newsletter. Several of the newsletters I paid for quietly disappeared when they took obviously large losses in their stock picks.
4) Costs: Even if you could find a financial newsletter that consistently beat the market, the subscription costs would often negate any advantage you have over the overall market.
I’ve been subscribed to about 30 financial newsletters and tracking their performance versus the overall stock market. Of those newsletters, only four of them have consistently beat the market over the past 3-5 years. However, the subscription costs associated with owning those four winning newsletters do not justify the advantages they’ve had over the market. In the end, owning a low cost total stock market index fund like VTI would outperform just about any financial newsletter subscription you could buy, when you figure in all the costs involved.
In my free book The Stock Market Rotation Quickstart Guide (which I’ve temporarily unpublished so I can update it), I mention that I’ve beaten the market in the long term using the methodologies outlined within. However, as you could see from the scorecard I placed prominently on my website, I’ve underperformed the market by about 20% over the last three and a half years. Over the past several months, I’ve been reading financial books, crunching numbers, and trying to understand why my picks have been underperforming the market in recent years. These are my conclusions:
1) Systemization: In the past, I’ve relied a lot on my own experiences and intuition when choosing stocks to buy. For the Stock Market Rotation Quickstart Guide however, I’ve attempted to systemize my approach to remove guesswork and intuition from the process. However, as Ben Graham alluded to in his classic book The Intelligent Investor, once a stock picking strategy gains acceptance, its reliability diminishes. Graham cites two major reasons for this phenomenon: “First, the passage of time brings new conditions which the old formula no longer fits. Second, in stock-market affairs the popularity of a trading theory has itself an influence on the market’s behavior which detracts in the long run from its profit-making possibilities.” This explains why my intuitive approach may have worked for me, but my systematic approach failed.
2) Overdiversification: There is a such thing as overdiversification. Most experts tend to agree that it’s best to hold 10-30 stocks at a time. Using my Stock Market Rotation methods, I would own about 78 stocks at any given time, and rotate them out every year or two. However, this might have spread my picks too thin, as sometimes I would have to choose stocks to buy for which I didn’t have the highest conviction. On this, Ben Graham wrote, “If one could select the best stocks unerringly, one would only lose by diversifying.” Overdiversification kept my portfolio from taking significant losses, but it also kept it from making significant gains.
3) Active management: My time horizon of about one and a half years was longer than most portfolios, but also too short to allow for long-term trends to play out. We’re in this game for life, so a time horizon measured in months doesn’t make sense. The Motley Fool recommends a stock time horizon of 3-5 years. However, I’m thinking perhaps 10-20 years is more ideal. Imagine if you had purchased Wal-mart stock back in 1993 when the company was taking over American retail. You might have purchased the stock for about $13 a share. If you had a 1.5 year time horizon, you would probably have sold it in 1995 at a loss for about $12 a share. If you had a 3-5 year time horizon, you might have sold it for $17 a share after watching it rise past $19, then tank to below $16 a share. However, if you had a 10-20 year time horizon, you probably would have sold it at about $58 per share after watching it drop 10% then rebound. If you had the mentality to keep the stock forever, it is worth about $150 per share today, or over 10x its 1993 value.
Adjustments need to be made. I’m not going to cover up past underperformance, but I am going to make a few big changes to hopefully turn things around. In the grand scheme of things, the Stock Market Rotation portfolio is an experiment to see if I can beat the overall market in the long term when over 90% of professionals have failed.
Going forward, I’m going to make only one stock pick per month and hold each stock for at least five years before reassessing its long-term prospects. I’m going to take a more intuitive approach to stock picking with an eye toward how it fits in with long term trends.
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