There are five reasons why you should avoid stock picking. And many more reasons why financial advice and investment management are likely to be better.
You may dream of being the next George Soros or Warren Buffett. You may imagine making millions by choosing the right combination of shares. For most people, however, stock picking is fraught with risk and likely to lead to tears, not triumph.
Picking the winners consistently is impossible for the average investor. Even experts struggle to get it right. Buffett himself said most people shouldn’t pick individual stocks – read on to find out why he’s right.
What is stock picking?
Put simply, stock-picking means investing in the stocks you think will outperform the market. It’s a strategy used by both DIY investors and those in fund management. Remember, though, that fund managers are supported by a small army of analysts.
To decide whether a stock is a good investment opportunity, stock pickers assess factors such as the company’s price, dividend yield, earnings forecasts, growth opportunities, and market dynamics.
The opposite of stock picking is index investing, where investors place money in funds that track an index, like the FTSE 100 or S&P 500.
Stock pickers claim they can beat the market
Stock pickers say the main benefit of their approach is it offers the chance to beat the market. They compare their potential returns with an index fund, the returns of which are decided by the index it tracks.
Granted, if you’re one of the few to be successful, stock picking can generate big returns. If you’d invested in Apple two decades ago, you could be sitting on a total return of nearly 13,000%.
The keyword is ‘if’. Regrettably, many stock pickers make decisions that turn out to be wrong and, in the process, lose a significant amount of money. As Buffett says: ‘Risk comes from not knowing what you’re doing.’
Five reasons why stock picking is a bad idea
No one can predict the future
Many amateur investors think that building up enough knowledge will let them predict the future of a stock. The truth is, no one can. You can study earnings forecasts and dividend yields all day, every day, but unforeseen events can turn everything on its head.
You only need to look at the upheaval that coronavirus created to see how events outside our control can mess up seemingly bullet-proof investment strategies.
Things aren’t always as they seem
Often, a certain stock can seem as safe as houses. But then a scandal arrives – related to management, accounting or operations, whatever – and before you know it, the price goes through the floor.
A great example is Patisserie Valerie. Investors loved this pastry-café chain, but it collapsed into administration following the discovery of a £40 million black hole in its accounts.
High fees eat into your investment returns
Actively trading stocks can be expensive. Every time you buy and sell a stock you must pay a trading fee, which can be upwards of £10 per trade.
Fees soon add up and, over time, they eat into your investment returns.
If you invest £500 in a stock and you’re charged £10 to buy it and another £10 to sell it, 4% of your initial investment will have been eaten away by trading fees. So, you need 4% growth just to cover those expenses.
It’s difficult to diversify
Ensuring your investment portfolio is diversified is incredibly important. All investments go up and down, but spreading your money across different asset classes, sectors, and geographical regions can help to cushion the blows.
As we’ve noted, however, trading stocks costs money, and those costs will increase, the more you diversify. Funds often contain 100+ stocks, which, if you bought them individually, would be very expensive.
Managing stocks is time-consuming and stressful
You need luck and perseverance to pick stocks, not to mention plenty of time. Fund managers employ a team of analysts who put in hours of research before deciding whether to invest in a company.
Even if you manage to do enough initial research, you’ll need to monitor your portfolio regularly. And if you’re continually fretting over whether to sell this or that stock, you’d better have a good tolerance for stress.
A better approach to investment management
Instead of picking stocks and hoping for the best, good financial planning involves deciding on your financial goals and then building a healthy, balanced portfolio that lets your money grow over the long term.
Some of the ‘golden rules’ you should stick to include:
- Let the markets do the heavy lifting
- Take a disciplined approach and avoid knee-jerk reactions
- Build and maintain a globally diversified portfolio
- Keep costs low
- Invest for the long term
- Get the right balance between risk and return
Aim to ignore the expensive marketing hype of the so-called winners. The TV game show Who Wants To Be A Millionaire aired in the UK in September 1998, which is 22 years ago (with a 2014-2018 gap). You may have wondered how many won the jackpot in all that time. We can tell you. A grand total of six.
It’s much the same in the financial markets. It’s the winners that we remember, and the winners that get the hype.