So You Think You Can Pick Stocks?

So You Think You Can Pick Stocks?

The year 2015 may or may not be remembered as the year that ended one of the longest U.S. stock bull markets in history, but for those of you holding individual stocks in your portfolio, it will probably bring to mind the thrashing that their prices have undergone. Volatility, of course, should be nothing new to investors that survived 2008. But if you like to purchase individual stocks, it’s worth taking another look at why you chose them and why you still own them

A study by JP Morgan last year discovered that investing in individual stocks is somewhat akin to investing in the lottery. They examined all U.S. stocks that were part of the Russell 3000 index (the top 98% of all U.S. stocks) at any time during the period 1980-2014 and found that:

  • 40% had a negative total return.
  • Two-thirds underperformed the index.
  • 40% suffered a catastrophic loss defined as a permanent 70% or greater decline from their peak value

In other words, if you had simply invested in a Russell 3000 index fund, you would have had a 66% chance of doing better than investing in a single stock from the index. And as if that weren’t sobering enough, over 320 companies were deleted from the S&P 500 during that period for business distress reasons. In other words, out of the top 500 companies in the U.S., over 320 had severe enough problems for Standard & Poor’s to kick them out of their index

But perhaps you could do better by investing only in high tech companies. Unfortunately the performance of that sector turned out to be even worse. Despite generating some of the most spectacular gains in the history of U.S. equity markets during that period, over 70% of tech sector stocks underperformed the Russell 3000, over 50% had negative total returns, and almost 60% encountered catastrophic losses

You might think that fundamental analysis – in which you consider a company’s performance, the management team, its competitors, etc. to assess its future prospects – ought to be a fairly rational methodology for selecting individual stocks. Alas, the JP Morgan study concluded that “no matter how well you know your industry and your company, no one is impervious to event risk and industry changes…exogenous forces may overwhelm the things we can control.” Here are just a few of the events they identify that are outside of management control and that can put a company (and its stock price) at risk:

  • Commodity price risks that cannot be hedged away
  • Government action (noting that deregulation has been just as disruptive as re-regulation)
  • Foreign competitors subsidized by their governments’ actions
  • Intellectual property infringement
  • Changes in U.S. or foreign government tariff or trade policy
  • Technological innovation leading to disintermediation or replacement
  • A shift in buying power to the firms’ customers or competitor

Even those few investors that hit the jackpot with Disney, the stock that had one of the greatest returns (128,000%) since its introduction nearly 60 years ago, probably wouldn’t have held on for the entire stretch. According to Michael Batnick, Director of Research at Ritholtz Wealth Management, during over thirty of those years Disney’s stock price fell by 20%, and by as much as 50% during fifteen of them

Clearly investing in individual stocks is not for the faint of heart. And since the goal of investing should really be about growing your savings sufficiently to support your lifestyle goals during retirement, rather than attempting to strike it rich, you’d be better off utilizing more diversified mutual funds or ETFs.

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