Thursday, January 12, 2012

Second Look: Investing in Individual Stocks

Writing this blog has taught me a lot about personal finance and investing. This is one of a series of articles where I argue with my former self by disagreeing with one of my previous articles. Unlike politicians, I’m allowed to change my mind as I learn more from my readers and my own research.

In a series on investing pitfalls, I wrote an article warning readers about overconfidence, where I said
“There is nothing wrong with investing in individual stocks if you are truly knowledgeable and willing to put in the time to follow the companies you own.”
I used to believe that smart people willing to put in the work to pore over annual reports and financial statements could beat the stock market averages. Former self, I think you are wrong. I no longer believe that intelligence and hard work are enough. There are too many brilliant people trying to do the same thing. Unless you are a true financial genius or have access to inside information, I’m pessimistic about your likelihood of keeping up with average market returns over the long run.

Sadly, I know too many small investors who think that following stock prices and calculating dividend yields qualifies them as stock experts.

On the Positive Side …

Here are a few of my older articles that I still quite like:

What is a mutual fund? Here I tell a story designed to explain the different players involved in mutual funds and their motivations.


Why does my financial advisor seem to work for free? This is the story of how years after investing in mutual funds I came to understand how my financial advisor was paid.

What is an MER? Aimed at novices, this article explains management expense ratios and why small percentages matter.

12 comments:

  1. Anyone with an above average IQ and wisdom can beat most indexes most of the time.

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  2. @Dale: I'm surprised you still spend time commenting on blog posts instead of enjoying your trillions from beating most indexes most of the time.

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  3. There's an interesting aspect to the debate between individual stocks and index funds that's frequently overlooked. Owning index funds forces you to trade. Indexes get rebalanced, stocks get added and subtracted, etc... The amount of trading is small, but it ads up over time. I'm sorry that I can't provide a link for this, but there have been back-testing studies done of the outcome of buying the constituents of an index like DJIA and then holding them vs. replicating the changes in the index over time, and the results were not indisputably in favour of mirroring the index's changes. Clearly, most people who buy individual stocks do in fact trade them, but they don't have to.

    Another issue for us Canadians is the ridiculously lopsided weightings of our broad market indexes. The TSX60 is 75% resources and financials. Is there good evidence that strategies that work in a more diversified economy like the US necessarily work in Canada? In a small market like Canada, indexes sometimes to crazy things... wasn't Nortel 40% of the TSX60 at it's peak?

    I'm generally on the side of the indexers, but I don't think it's foolish to look at the Canadian market and make a decision to own the index + individual stocks, particularly if you have the discipline to trade infrequently. On an absolute basis, XIU seems riskier than a more balanced portfolio of Canadian equities.

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  4. @Matt: I'm content to follow the index changes mainly because I find it impractical to try to own enough stocks to create my own version of the index. Maintaining a portfolio spread across multiple accounts can become complex quickly. My wife and I have 9 different accounts that cannot be merged without negative tax consequences. Maybe if I had a million dollars in each account I'd consider buying individual stocks to mirror the index myself. But even then I wouldn't trust myself to judge which index changes I should follow and which I shouldn't.

    The solution I use to the problem of "lopsided weightings of our broad market indexes" is to limit the percentage of my portfolio that is invested in Canadian stocks. If for some reason I had to invest 100% in Canada, then I'd be concerned about the lack of balance in Canada.

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  5. @Michael "My wife and I have 9 different accounts that cannot be merged without negative tax consequences. " I'm not sure why this is the case.

    Assuming the same person owned the sames accounts, you should be able to move stocks from one account to another without having to dispose of them. Hence no tax implications.

    The only problem I could see is if the accounts have different owners (for example transferring stock from Mr. James' account to a joint accounnt owned by Mr. and Mrs. James).

    Please, correct me if I'm wrong on this one. :)

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  6. @Paul T: The accounts are RRSPs, LIRAs, TFSAs, spousal RRSP, and non-registered. None can be merged without some negative tax implication. Maintaining a portfolio across all of them adds some complexity and extra trading costs compared to just one big account.

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  7. Hi Michael, funny my thoughts are heading in the opposite direction. Most of the brilliant people seem to be more interested in collecting fees than in doing smart investment analysis. There a more investment securities - stocks, bonds, not funds - than brilliant properly-motivated people around. There is a spectrum of ability in any field of human endeavour. Why should investing be any different? I get a feeling that you equate brilliant people with institutional investors. But the brilliant people don't necessarily work for an institution.

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  8. @Michael Merely millions, not trillions. I fear that you suffer from living in a blog cocoon or echo chamber where you only hear from like minded index-zealots.
    Wisdom requires some independant thought. Step outof your chamber; you can do it!

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  9. @Canadian Investor: I'm not sure that I follow your line of thought. I agree that there is a spectrum of investing ability. My assertion is that you need to be a long way toward one end of the spectrum to be able to beat the index consistently. I don't know that I'd call all institutional investors brilliant, but the big players do employ many brilliant people and give them access to great tools and useful information.

    Whether they are brilliant or not, institutional investors are the competition for active investors. When you trade stock, the odds are in the 80% to 90% range that an institutional investor is on the other end of the trade.

    @Dale: Always ready with the personal insults, but short on conveying useful ideas. You never disappoint.

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  10. @ Michael; not an insult, merely an invitation.

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  11. Hi again Michael,
    My point is that the brilliant people within institutions often exercise their brilliance at collecting fees rather than actual investing, or their brilliance is subverted by herd behaviour, closet indexing etc. Yes, they have more convenient tools, though the Internet has much reduced that advantage, and often inside information but not many institutional investors exploit it.

    As for the necessity of being "on the end of the brilliance spectrum", to beat the index only involves beating the average. Warren Buffett somewhere said that a person of normal intelligence can be successful at investing, it is the behavioural stuff that does most people in. Most people don't have the motivation to learn the basic accounting methods and to apply themselves in a disciplined manner. As you say, looking up a dividend yield is a feeble attempt at analysis and does not equate to poring over financial statements.

    It is easy and relatively little effort to do passive index investing and it works quite well, so for most people it makes sense.

    The fact ordinary people don't want to pursue active investing, or they do not do it properly, doesn't imply it is impossible. Investing isn't theoretical physics.

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  12. @CanadianInvestor: It's interesting that you mention that investing isn't theoretical physics because the investment industry employs many physicists. I agree with you that behavioural problems cause many people to badly underperform the stock market averages and it is certainly possible to avoid such pitfalls, but this is not enough to be able to outperform the index. A typical intelligent and rational person can invest actively and underperform the index by less than the typical large gap, but having an expectation of beating the index over the long term is another matter entirely.

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