Should Individual Investors Stop Picking Stocks?

There is an interesting article on Slate by Henry Blodget entitled, “Stop Picking Stocks—Immediately! Why the world’s greatest stock picker stopped picking stocks, and why you should, too.”

Blodget points out that the market has become much more efficient in the internet era. He contends that stock pickers have the deck stacked against them, and that they would do much better if they bought low-cost index funds and let it go at that.

In support of this thesis, Blodget quotes Benjamin Graham, from a 1976 article in the Journal of Finance:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when [the bible of fundamental stock analysis, Graham and Dodd’s Security Analysis] was first published; but the situation has changed. I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost.”

Blodget adds that Graham had come to favor a simpler stragegy of screening stocks using simple valuation and fundamental criteria and incorporating them into diversified portfolios.

There is certainly some truth in this. The average small investor can not expect to beat the market, but he or she can easily equal market returns through passive investment in index funds.

But that still leaves the question of which index fund this hypothetical passive investor should choose, and whether additional investments should be made in bond funds, international index funds, and so on. The possibilities are mind-boggling! Stock-picking is replaced by fund-picking. Also, unless he sticks to one index fund, the passive investor must make continuous decisions about sector weighting, reinvestment and rebalancing which can have a profound impact on the bottom line. But the goal of matching the market’s return will still be hard to achieve for various reasons, including investment expenses and transaction fees, and there is no hope of beating the market.

If I were starting out today I would definitely begin with a foundation of carefully chosen low-cost index funds and accumulate shares through dollar cost averaging. But I think that if someone has the time, educational background, and aptitude, and is willing to work hard, it is still possible to supplement the index funds with individual stocks which will provide superior results, boosting overall returns and providing satisfaction which can not be achieved through passive investing.

Comments

[huangjin:]

The market will never be truly efficient because everyone has their own value of risk and return. If you are in-line with the majority thinking, just indexing would make sense. As long as the majority is right.

2007 Jan 26 06:09 PM

[Malkiel:]

I agree with the basic conclusion in the last paragraph, but not with the overall proposition that somehow the era of instantaneous information has put the small investor at a growing disadvantage. If anything, the small investor is now better-armed than their mighty foes; online live-time trading and price info from sophisticated platforms with instantaneous clearing and ever-shrinking discount fees allow the investor with small positions to weave and bob more effectively than institutional goliaths. The last great barrier for the value investor is the psychological barrier of not wanting to buy and sell without vast Talmudic study, which is more about guilt complexes than it is about effective strategy. Selling, and to a lesser extent buying, on price action alone in fast-moving markets is a rational tool for the arsenal of the value investor but will always feel "sinful" to investors of a certain personality profile (and congenital bears are whipped value investors who can never cleanse themselves by giving in to the dark side...)

2007 Jan 26 07:06 PM

[Guadi:]

A focus on total return within a proper asset allocation while maintaining a sell discipline for the mildly speculative portion of a portfolio will do just fine as long as transaction costs are kept low. My personal clients have outperformed the indicies for a few years running now and, barring a collapse in the bond market (although cash is an asset class as well) should continue to outperform. The biggest obstacle to performance is the fairly common concern about taxes on the income generated along with short term gains. Proper portfolio management can minimze tax consequences while outperformance can continue. The biggest obstacle to performance is shortsightedness and failure to focus on the big picture, in other words, investor psychology. The problem with basic equity indexing is the lack of net dividend cash flow.

2007 Jan 27 10:36 AM

[Barry Brown:]

This may be an oversimplification, but I have invested substantially in a mutual fund that has outperformed the SP500 by 1.65% over its life (since 1988) and 3.07% since I've owned it (1996). My thinking was that luck could not explain this phenomenon. So what is wrong with my approach: find a fund that consistenly outperforms its benchmark and invest in the fund instead of the benchmark.

Incidentally, the fund is Longleaf Partners and they have outperformed with low beta and low turnover (mostly LTCG).

2007 Jan 28 09:45 PM