Team Favorite At the Money: Should You Be A Stock Picker?

Summary

Masters in Business: Team Favorite At the Money – Should You Be A Stock Picker?

Episode Release Date: December 18, 2024
Host: Barry Ritholtz
Guest: Larry Swedroe, Head of Financial and Economic Research at Buckingham Strategic Wealth

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Introduction to Stock Picking

In this episode of Masters in Business, Bloomberg Radio host Barry Ritholtz delves into the perennial debate of whether individual investors should engage in stock picking or stick to broader investment strategies like index funds. To unpack this topic, Barry is joined by Larry Swedroe, a renowned expert in investment research with over $70 billion in client assets under management and 20 co-authored books on investing.

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The Pitfalls of Stock Picking

Barry opens the discussion by challenging the value of stock picking, asking Larry about the inherent problems with selecting a few standout stocks for one's portfolio.

Larry Swedroe responds at [01:26], "If it's done for an entertainment account... the evidence is very clear that stock pickers on average lose because of their trading costs, not because they're generally dumb." He elaborates that while stock picking can be tempting for its entertainment value, the average retail investor often underperforms due to higher trading costs and behavioral biases.

Swedroe highlights that retail investors are frequently drawn to "lottery-like stocks," such as penny stocks or high-growth small-cap companies, which generally underperform. He notes, "Those stocks have underperformed treasury bills, but they're the favorites of the retail investors and the institutions avoid them, giving them somewhat of an advantage." (02:48)

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The Myth of the Great Stock Picker

Barry challenges Larry by citing legendary investors like Peter Lynch, Warren Buffett, Carl Icahn, and Bill Ackman, questioning why their success isn't easily replicable by the average investor.

At [03:08], Larry Swedroe acknowledges that while certain individuals like Peter Lynch and Bill Ackman have demonstrated exceptional stock-picking abilities, the broader market proves otherwise. He argues, "The research shows that Buffett generated massive out returns not because of individual stock picking skills, but because he identified certain traits or characteristics, statistics of stocks that if you just bought an index of those stocks, you would have done virtually as well as Buffett did in the stock picking."

Swedroe emphasizes that modern investment strategies and mutual funds mimic these traits, effectively neutralizing the unique advantages once held by top investors like Buffett. He explains, "Buffett's Berkshire has not outperformed in the last couple of decades because the market is caught up to him and eliminated those anomalies, if you will." (04:52)

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The Statistical Odds Against Stock Picking

Barry brings up the impressive returns of companies like Netflix and Nvidia, questioning if targeting such high-growth stocks can enhance portfolio performance.

Larry Swedroe counters this optimism at [05:13], "Only 4% of stocks have provided 100% of the risk premium over T-bills. What are the odds you're going to be able to find those stocks?" He further points out that while standout performers like Nvidia exist, the majority of stocks—approximately 96%—underperform the market. Swedroe states, "The odds are you're going to pick the underperformers, not the outperformance. That's simple math." (05:13)

This stark reality underscores the difficulty of consistently identifying and investing in the few high-performing stocks amidst a sea of underperformers.

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Emotional Biases in Investment Decisions

Barry probes into how emotional biases might influence individuals to believe they can successfully pick stocks compared to investing in broad market indices.

At [07:58], Larry Swedroe addresses the psychological challenges, stating, "People tend to be over optimistic, overconfident in their skills... 90% of the people think they're better than average... but studies have shown people who thought they outperformed actually lost money in the years." Swedroe highlights the impact of overconfidence and selective memory, where investors remember their successes and forget the numerous failures, skewing their perception of their own abilities. (07:58)

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The "Cowboy Account" Approach: A Cautious Experiment

Barry introduces the concept of a "cowboy account," where investors allocate a small percentage (less than 5%) of their portfolio to speculative stock picking as a hobby.

Larry Swedroe responds thoughtfully at [09:15], "Taking 5% of a portfolio is not likely to cause you great harm. And if you don't do a lot of trading and you build a little bit of diversified, you're probably going to get something like market returns." He suggests that while such an approach can satisfy the desire for active participation without significantly jeopardizing the overall portfolio, it rarely leads to substantial additional returns. Swedroe adds a philosophical note: "If you need to get enjoyment out of stock picking to have a good life, I suggest you might want to get another life." (09:15)

He emphasizes that the marginal gains from a small, diversified speculative account are minimal compared to the time and effort required, which could be better spent enjoying personal life activities.

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Conclusion: The Case for Broad Index Investing

As the discussion wraps up, Barry summarizes the insights:

• Larry Swedroe asserts that investors aiming to outperform through stock picking face long odds, as the majority of stocks underperform broad indices.
• Stock picking introduces additional risk and volatility without guaranteeing superior returns.
• For those seeking the excitement of stock selection, allocating a small portion of their portfolio to speculative investments is acceptable, but the core of their investments should remain in diversified, low-cost index funds.

Barry concludes with a key takeaway: "Investors who think they could become winning stock pickers face long odds. If you wanna set up a cowboy account with a tiny percentage and play with it, knock yourself out, have some fun, just recognize that's all it is. And your real money should be locked away and working over the long haul for you." (10:05)

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Final Thoughts

This episode provides a compelling argument against active stock picking for the average investor, backed by statistical evidence and behavioral psychology. Larry Swedroe's expertise underscores the value of disciplined, passive investment strategies over the uncertain and often counterproductive pursuit of individual stock selection.

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Notable Quotes:

• Larry Swedroe [01:26]: "If it's done for an entertainment account... the evidence is very clear that stock pickers on average lose because of their trading costs, not because they're generally dumb."
• Larry Swedroe [04:52]: "Buffett's Berkshire has not outperformed in the last couple of decades because the market is caught up to him and eliminated those anomalies."
• Larry Swedroe [07:58]: "People tend to be over optimistic, overconfident in their skills... 90% of the people think they're better than average... but studies have shown people who thought they outperformed actually lost money in the years."
• Larry Swedroe [09:15]: "If you need to get enjoyment out of stock picking to have a good life, I suggest you might want to get another life."
• Barry Ritholtz [10:05]: "Investors who think they could become winning stock pickers face long odds. ... your real money should be locked away and working over the long haul for you."

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This comprehensive analysis guides investors to critically assess the viability of stock picking, advocating for evidence-based, diversified investment approaches to achieve sustained financial success.

Transcript

[Hannah Fry]

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[Unknown Singer]

Cause I'm a picker I'm a grinner I'm a lover and I'm a sinner.

[Barry Ritholtz]

I'm Barry Ritholtz. And on today's edition of at the Money, we're going to discuss whether or not you should try your hand at stock picking. It's fun, it gives you stuff to talk about at parties. But is it profitable? To help us unpack all of this and what it means for your portfolio, let's bring in Larry Swedro, head of financial and economic research at Buckingham Strategic Wealth. The firm manages or advises on over $70 billion in client assets. And Swedro has written or Co written 20 books on investing. So Larry, I know you're not a big fan of stock picking. What what's the problem with throwing a couple of great stocks into your portfolio.

[Larry Swedroe]

If it's done for an entertainment account? In the same way that we don't expect to get rich going to Las Vegas, no one would invest their IRA in the casinos of Las Vegas or go to the racetrack with it. So that's okay if you're prepared to lose. The evidence is very clear you that stock pickers on average lose because of their trading costs, not because they're generally dumb. Although I will add this, Barry, the typical retail investor is actually dumb or naive and they get exploited by institutional investors. And it's a lot to do with biases. On the behavioral side, they like to buy what are called lottery like stocks, things that the vast majority of the time do poorly, but occasionally you find the next Google. So stocks they like to buy include things like stocks and bankruptcy, penny stocks, small cap growth stocks with high investment and low profitability. Those stocks have underperformed treasury bills, but they're the favorites of the retail investors and the institutions avoid them, giving them somewhat of an advantage.

[Barry Ritholtz]

I know you wrote a book about what a great investor Warren Buffett is and how we can invest like him. Peter lynch was a great stock picker. Carl Icahn, Bill Ackman, all these different Fidelity fund managers have been great stock pickers. How hard can it be? Why can't we just go out and pick a few great stocks and that's our portfolio, right?

[Larry Swedroe]

Okay, so let's start with the premise that markets are not perfectly efficient. There are a few people who have managed to outperform for whatever reason. And I would agree with you that Peter lynch certainly was a great stock picker. Maybe Bill Ackman you could add. I would disagree with Warren Buffett being a great stock picker, taking nothing away from what Buffett did. But the research shows that Buffett generated massive out returns not because of individual stock picking skills, but because he identified certain traits or characteristics, statistics of stocks that if you just bought an index of those stocks, you would have done virtually as well as Buffett did in the stock picking. He has been telling people for decades to buy companies that are cheap, profitable, high quality, low volatility of earnings, etc. And the academics, through reverse engineering, though it took them 50 years to figure it out, now have identified these characteristics. And all of the mutual funds I use, run by companies like Dimensional Bridgeway, aqr, they all use the same strategies. And Buffett's Berkshire has not outperformed in the last couple of decades because the market is caught up to him and eliminated those anomalies, if you will. You can do the same thing. So takes nothing away from Buffett. He gets all the credit for figuring it out 50 years before everybody else. But it wasn't stock picking and it certainly wasn't market time.

[Barry Ritholtz]

So I know the indexes will give me 8, 10% a year annually and those are great returns. But Netflix is up like 1000% over the past couple of years and Nvidia is up 3000% over the past couple of years. Wouldn't that goose my returns if I can own companies like that?

[Larry Swedroe]

Yeah, that's certainly true, Barry, but we got a couple of problems with that. And but by the way, those kind of returns are the ones that encourage people to try to hit those home runs. The data shows this. Out of the thousands of stocks that are out there over the, you know, now of 100 years virtually of data in the U.S. only 4% of stocks, 4% have provided 100% of the risk premium over T bills. What are the odds you're going to be able to find those stocks? Problem number two is people cite the Nvidia, but they also forget that last year, a good example, while the S and p was up 26.5%. Ten stocks underperformed by at least like 60%. At least 60%. They're down at least 32. So everyone likes to point out the winners, but you also then have a good shot at getting the losers. In fact, the odds are you're going to pick the losers. Here's why. Because only 4% of all the stocks account for all the outperformance. That means the average stocks underperforms the average. So the odds are you're going to pick the underperformers, not the outperformance. That's simple math. So the more stocks you own, the better your odds of earning the average.

[Barry Ritholtz]

So if I'm a stock picker and I have a full time job and I'm doing this, you know, on the side, what sort of performance should I expect?

[Larry Swedroe]

Should expect a performance that if you are familiar with asset classing, asset class pricing models. So if you buy a large value stock, you're probably going to get the returns of a large value index, but with a lot more volatility because you own one stock instead of maybe 200. So you could have what's called tracking variance around that of 5 or even 10%. But the more stocks you own, the close you're going to get to that index. So why bother? You're better off just owning the index at very low cost. You don't have to spend any time doing it. Your life will probably be a lot better because you'll spend more time with your wife and your kids, enjoying a nice round of golf or a walk in the park, or do what I do, playing with my grandkids. Get a lot more pleasure out of that than trying to pick stocks or time to market.

[Barry Ritholtz]

What about emotional biases? How do they affect people who think they could go out and pick the winning stocks versus simply owning a broad index?

[Larry Swedroe]

Yeah, there's certainly that. Emotional biases are part of the reason people think they're going to outperform. The research shows, for example, that we're human beings and we tend to be over optimistic, overconfident in our skills, so that 90% of the people think they're better than average, regardless of the endeavor, whether it's whether you're a better than average driver, a better than average lover or a better than average stock picker. So you think you're likely to outperform. In fact, studies have shown people were asked, did you outperform? And by how much? The people who thought they actually outperformed actually even lost money in the years not only did they not outperform, so his selective memory creates a problem as well.

[Barry Ritholtz]

Amazing. One of the things I've heard people talk about is setting up a small, what I've heard described as cowboy account where they can throw caution to the wind. They take less than 5% of their liquid assets and that's as much as they're willing to risk and allows them to scratch that itch of either stock picking or whatever it is. What are your thoughts on that sort of approach?

[Larry Swedroe]

Taking 5% of a portfolio is not likely to cause you great harm. And if you don't do a lot of trading and you build a little bit of diversified, you're probably going to get something like market returns. And if you follow the research as presented in my books, you can avoid those lottery stocks improving your odds, you know. But my question to you is, if you need to get enjoyment out of stock picking to have a good life, I suggest you might want to get another life. Now, I say that with tongue in cheek because people like to go to the racetrack and, you know, go to the casinos. There's nothing wrong with that. But if that's what you really need to enjoy your life, you might want to think about where your values are. Again, I say that with tongue in cheek though.

[Barry Ritholtz]

So to wrap up investors who think they could become winning stock pickers face long odds. Most of the stocks that are out there will underperform the index and certainly not be a source of outperformance. The odds are that they're going to add risk and volatility while spending a lot of time and effort to pick stocks. And the key takeaway is they're gonna underperform a broad index anyway. That's what they need to understand. If you wanna set up a cowboy account with a tiny percentage and play with it, knock yourself out, have some fun, just recognize that's all it is. And your real money should be locked away and working over the long haul for you. I'm Barry Ritholtz and this is Bloomberg's at the Money.

[Unknown Singer]

Cause I'm a picker, I'm a grinner I'm a lover and I'm a s. I play my music in the sun.

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