Imagine for a minute that Sean is standing across the room from me. He is holding a piece of string he needs to cut. Wanting to be helpful, I take a kitchen knife, hand it to an 18-month-old child, give him a gentle nudge in the back, and tell him, “Go give this to Sean.” Off the young lad goes, stumbling across the living room in Sean’s general direction.

How’s that going to turn out? We don’t really know, do we? The visual I conjure at the thought even makes me a bit anxious. Not a pleasant feeling. Let me proceed!

It could turn out fine. The child may arrive safely at Sean, who disarms him and cuts the piece of string. Exactly as I had planned it.

It could turn out even better than expected. With a random-but-fortunate wave of his young arm that child tottering across the room might cut my roast beef sandwich into smaller bites. Then I could eat at my keyboard without making such a huge mess. That would be a result even better than I expected!

Then again, that child could stumble, and in the morning we’d find ourselves on the lookout for a new dog. A very poor result, indeed.

Let me assure you that no toddlers, dogs, or roast beef sandwiches were harmed during the writing of this post, and amid all this silliness I actually have a point: There is probably a better way to get that piece of string cut. We could find a way to accomplish what we need to accomplish without taking on so much uncertainty, so much extra risk. There is a similar phenomenon in investing.

Picking Individual Stocks Increases Portfolio Risk

When I find individual stock picks in someone’s portfolio I see a child with a knife running through the living room. How’s that going to turn out? We just don’t know. It could be better than expected. It could be worse. But there is a way to accomplish what needs to be accomplished without taking on so much extra risk. It is known as index investing, and we are great believers in it at Redeployment Wealth Strategies. (We especially like the refinements Dimensional Funds puts on index investing. More on that coming soon! For now let’s just talk about the pitfalls of picking individual stocks.)

I’ve heard it said, “Picking individual stocks is not risky if you know what you are doing.” I answer that with a “Yeah, maybe.” I’m not taking the position that certain ultra-successful investors like Warren Buffet got where they are based on luck and not skill. I can accept that some people have that skill. What I don’t accept is someone’s self-evaluation of their own ability. I am skeptical in most situations, and this is amplified when I hear people talking about money. (Especially their own money.) Most of us are downright awful at assessing our level of skill at something. Add to that the exceptional influence of money on our emotions and we can be flat delusional about our ability to pick stocks. So I might concede a person can mitigate risk as a stock picker by ‘knowing what they are doing’, I just don’t concede the stock picker knows whether or not s/he knows what s/he is doing.

Academic research supports my skepticism. In a recent interview with the American Association of Individual Investors magazine, the psychologist-turned-financial- advisor Dr. Daniel Crosby noted, “The correlation between self-reported investment performance and actual investment performance is indistinguishable from zero.” Translation: there is no relationship between what people say their portfolio is doing and what their portfolio is actually doing.

So, if you tell me you’ve been picking your own stocks and beating the market for decades I am not likely to believe you. Not because you’re stupid. Because you’re human. Not because it isn’t possible for a human to beat the market, it’s just so overwhelmingly unlikely. (Hint: if you take it personally that I don’t believe you, then I am even less likely to believe you. Being emotionally tied to the perception that you are a ‘smart stock picker’ is a very bad omen for your portfolio.)

One more thing – don’t fool yourself into believing picking a ‘solid name’ is going to mitigate your risk. Over the past 5 years the S&P 500 index is up roughly 50%. During that same time, shares of General Electric, once the world’s highest valued corporation, have lost about 75% of their value. It started this economic cycle as one of the safest bets on Wall Street, and now it has some pundits predicting it’s collapse. Being a blue chip stock is no guarantee of safety.

Pick Stocks for Entertainment, Not to Reach Your Financial Goals

I get it, though. Picking stocks is fun. There is a thrill to matching wits against ‘the market’ and getting your money in the game with a chance to win big prizes. I’ve been there and done that. Just be aware that buying a stock for the adrenaline rush is not investing. It’s entertainment. If you have enough money rationally invested to meet your financial goals, but you still have some leftover to pick a few stocks, then go for it. Knock yourself out if it makes you happy. Just be aware that you’re not investing, you’re engaging in a recreational activity.

I look at it like this: I know the rules of basketball. I can pass, dribble, and shoot. Yet, if I stepped onto a court with Lebron James it would be for a laugh, not to be competitive. There’s no comparison between his basketball skill set and my basketball skill set. Similarly, I’m not going to walk onto Warren Buffet’s court – the stock exchanges – and expect to compete. Not with your money or mine. Fortunately I can meet my financial goals just fine without getting ‘posterized’ by Lebron or Warren.  

I know quite a few investors who have tried their hand at picking individual stocks. Things usually go pretty well for them…until they don’t.  Like most things, I learned a few costly lessons the hard way. I tried my hand at stock picking a couple of decades ago. So, don’t be embarrassed if you have a knife-toting toddler or two running through your portfolio. It is a sign you’ve been interested and engaged. Don’t just sell them to get rid of them, either. There could be tax implications to selling securities and we want to know what they are before we just blindly sell. If you’d like some assistance with that, or if you’d like to discuss rational portfolio management to meet your life goals, call (757) 752-8055.