The Big Picture for the Week of September 2, 2012

The Big Picture for the Week of September 2, 2012: New York Magazine had an article about an SEC study that long story short concluded that stock picking should mostly be left to professionals. The article was mostly about financial literacy, there was a little about the disadvantages that retail investors face and it concluded rather directly that;

it's basically impossible for the retail crowd to beat the market on any consistent basis

I think the framing of the argument as spelled out in the article is incorrect. If the context is the entire US population then yes stock picking will be a bad idea as only a very small portion of the entire population will have the inclination to spend the time needed to own individual stocks. Most of the US population's attachment to the stock market is through a 401k where picking stocks isn't an option anyway.

From there the conversation then needs to gravitate to the narrower subset of the population that participate in markets, should they pick individual stocks? I think this is the wrong question too. Individual stocks take more time than narrow based ETFs which take more time than broad based ETFs.

For people interested enough to spend the time the realistic answer is some combination of funds and individual stocks consistent with their level of interest and their perception of their own ability to analyze individual stocks. Portfolio size also matters. Someone who is very young might be very interested in markets but not begun to really accumulate enough to put into stocks yet.

Despite what some would have you believe there is nothing insanely risky or ruinous about owning a handful of dividend or large stocks in moderate weightings as part of a diversified fund portfolio. Take the following example of an investor who ten years ago put 5% each into Chevron (CVX), Microsoft (MSFT), Johnson & Johnson (JNJ) and Bank of America and then put the rest into some combo of  the S&P 500 (SPY), the EAFE Index (EFA) and emerging markets (EEM).

This seems plausible even if not ideal due to the overlap with SPY. The names were and still are widely held and widely known. According to Google Finance for the last ten years SPY is up 59%, EFA is up 57%, EEM is up 255%, CVX is up 192%, MSFT is up 25%, JNJ is up 24% and BAC is down 77%. The four stocks made for good sector diversification but obviously three of them lagged badly but if you do the math you can see there was nothing ruinous with the strategy and again the stock picking turned out to have been poor.

Depending on the weight to EEM that someone might have chosen ten years ago the portfolio could have come out way ahead of the S&P 500 despite the general poor performance of the individual stocks. The above numbers do no include dividends and JNJ is a client holding and a name we own in RRGR.

Now, ten years later the funds available offer a much wider selection for anyone so inclined to build a simple, mostly fund portfolio with a handful of individual stocks. Someone starting out today building a similar ten year portfolio as outlined above might use a low volatility fund instead of SPY, maybe a couple of country funds for developed foreign and of course there are now many more fund choices for emerging market exposure.

In thinking about picking four stocks one way to reduce the likelihood of choosing something that goes to zero would be to avoid a fad. The first thing that comes to mind here is solar. It is an immature industry and it makes sense to expect the landscape as we now know it will change. Given that many investors know more about foreign stocks than they did ten years ago maybe one or two of the four individual stocks could be foreign. It is very unlikely that the long standing big phone company or big energy company from a foreign country will go bust. The big oil company in Finland might go on to lag meaningfully for the next ten years like JNJ but is very unlikely to go bust.

I believe Neste Oil is the big oil company in Finland, it trades at 14.7 times 2011 earnings and yields  3.8% but we do not own the name it is just an example.

The example from 2002 forward may or may not have beaten the market depending on the weightings of the funds but it would not have ruined anybody either. The important thing from the standpoint of a do-it-yourselfer is that the funds covered a lot of ground and the stocks were not weighted where they could have been ruinous.

I would submit that not making potentially ruinous decisions, like 40% in BAC ten years ago, is more important than beating market. Also more important than beating the market is not doing anything truly stupid at the worst possible time like panic selling in March 2009. I'm sure many would say now that of course that was the low and a time to buy but obviously there were a lot of people selling stock or else the market wouldn't have been cascading lower. A third thing that is more important than beating the market is having an adequate savings rate during the accumulation phase.

So while excerpt quoted above may or may not be true it does not have to matter for investors who understand that their real goal is simply to have enough money when they need it.

DIGITAL JUICE