Wednesday, September 07, 2022

Bad, Bad Take On Individual Stocks

Peter Lazaroff had a short podcast episode titled Should You Invest In Individual Stocks. It doesn't take long to learn that he thinks the answer is no. He says "the only real reason someone would own an individual stock is because they think it will beat the overall market." 

I'm not trying to persuade anyone from using individual names or not but if you're not going to use individual stocks you might want to at least understand why you feel that way and Peter's opinion is not it. It is peculiarly first order thinking like he doesn't understand portfolio construction. 

Individual stocks, theme funds, industry funds and sector funds all have various attributes that you might expect from holding on to them. The typical regulated utility stock for example probably has a lower beta to the S&P 500 and might have a higher yield. Those are attributes you might want as part of a diversified portfolio but not the only attributes. Here's an example with Southern Company (SO) a big, regulated utility.


The yield chart along the bottom isn't correct. I think it is taking today's dividend versus the price in the past to get those higher yields. As a lower beta stock, you might think it would go up less and go down less and that appears to be mostly true with SO. The chart is price only, so add in another 3% annualized for the dividend. Even with the dividend, I'm sure it is up less than the S&P 500 but someone who understood what regulated utilities tend to do would hope for this sort of long term result. It's hard to imagine that investors pick a regulated utility expecting it to outperform the market. 

Contrast that with something like Amazon (AMZN). Huge growth potential, sky high valuations, high beta to the S&P 500, no dividend, you'd expect that one with these attributes would outperform, you'd certainly evaluate a name like this on that basis. 


Stock picking might be very difficult as Peter says and active managers might lag their benchmark the vast majority of the time, yes, but as an investor, if you're building a portfolio with individual stocks that you think will all outperform the stock market, ok but you are not building a diversified portfolio. You're probably building a portfolio full of names more volatile than the market and possibly vulnerable to the same threats. For example, a diversified portfolio that goes narrower than the broad index level will have some holdings that are pro-cyclical like industrials or semiconductors and counter cyclical like food or beverage stocks. 

Peter's generalization also ignores some of the nuanced concepts we talk about like barbelling or capitally efficient portfolios. 

Buy individual stocks, don't buy them that is up to you, it's all valid though. If you're preference is to use narrower funds like sector or industry funds, it's still the same in terms of each fund like that bringing its attributes to the portfolio or at least expected attributes. A consumer staples ETF is unlikely to outperform in an up market, that's ok, they tend to be counter cyclical due to their demand elasticity; eating will be the last thing to give in some sort of bad economic scenario. Compare that to a metaverse ETF, you're not buying something like for its defensive attributes, it won't have any. A metaverse ETF will either go to the moon or flounder, that's why you'd buy such a thing.

I would encourage anyone to lose the mindset of beating the market. Any one building a portfolio, pro or do-it-yourselfer, will have years where they beat the market and years where they lag. The bigger point is a process you can stick to, using whatever tools are best for you that ensure you don't make a catastrophic mistake like panic-selling at a major low, then watching the market then rocket higher without you. Do what you have to to stay reasonably close to the market over the long term which combined with an adequate savings rate and reasonable spending will get the job done.

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