Picking Stocks is a Sham. Start With Asset Allocation Instead

Attention newbie investors,

If the first thing you think about when you start planning your investing is what stocks you’d like to buy, then I have bad news for you: you’ve already lost!  I’ll admit I, too, started out this way as well, so don’t feel bad about it (but don’t feel great either.)  Most stocks do not beat the market in the long run and many of them will likely go to zero eventually.  In an index with hundreds or even thousands of stocks, the vast majority typically end up lagging the index while a few stocks give astronomical returns of at least 10-fold in a period of several years.  In other words, there’s a huge probability that the stock you pick will be a dud and a tiny probability that it’ll hit the jackpot which ends up working out to an expected yearly return of around 7-11%.  Besides, according to a study from 2012, stock picking and trading only contribute about 7% to the average portfolio’s return while Asset Allocation is responsible for 91.5%!

There’s no way you can predict in advance which of the few stocks in an index will deliver those astronomical returns (otherwise we’d all be filthy rich.)  You may have heard of the 80/20 rule or the Pareto Principle which states that 20% (or a small minority) of the inputs or causes are responsible for 80% (or the vast majority) of the results.  This principle has been observed regularly in the financial markets over the last several centuries, except the actual ratio is probably somewhere along the lines of 99/1 instead of 80/20.  I suppose this is a viable route if you had the time, diligence, and patience to thoroughly research 20+ different stocks in a wide range of industries.  But you can accomplish pretty much the same for a tiny fraction of the effort by buying index funds, if you don’t mind giving up your micromanaging and control freak tendencies.

Why everyone falls into the trap of stock picking when they first start investing still puzzles me to this day but I have a few theories (see if you can relate):

• It makes them feel they’re in control.
• It lets them make a statement (I like companies X, Y, and Z so I’ll buy those for my portfolio.)
• They hear about hot stock tips on CNBC, the Wall Street Journal, or others in the media.
• Their broker or financial advisor recommended a particular stock.

Let’s brief each of these reasons below:

It makes them feel they’re in control

Some people seem to have an ideal “vision” of how their portfolio should look, what specific stocks it should and shouldn’t contain, and when they shall get in and out of each stock.  In other words, they micromanage their portfolios, much like how they’d program the thermostat in their own home to be at a certain precise temperature for every single minute out of the day.  (Stock A should be 13.742859% of my portfolio, Stock B should be 9.2238223% of my portfolio, etc.)  Problem is, picking good companies to invest in is hard work and not an exact science.  Besides, it takes at least around 20 stocks in a portfolio in order to bring unsystematic risk down to a trivial level, and that is assuming the 20 stocks span a wide range of industries.  Most people tend to be subconsciously biased towards certain industries in picking stocks, usually either the industry they work in or a “hot” industry receiving a ton of media coverage.  Then when an unexpected problem or shock hits the industry that they’re heavily invested in like Tech in 2000 or Financials in 2008, their portfolio is decimated.

It lets them make a statement (I like companies X, Y, and Z so I’ll buy those for my portfolio.)

If you’re in love with a company and/or its products, do share about it on Facebook, your other social networks, forums, Youtube videos, blogs, etc.  But please don’t buy their stock just to make this statement!  Think about it for a moment: what bearing does your own feelings and emotions about a particular company have on the its future stock price?  You might think this excuse is almost laughable as you read it here but in practice, many people fall into this trap more often than they’d be willing to admit.  Whenever I’m chatting with many of my college buddies about investing, one of the most common reasons they cite for buying a particular stock is along the lines of: “I just like that company and its products.”  This screams extreme laziness, and although successful investing isn’t rocket science, it’s gonna take more effort than that.

They hear about hot stock tips on CNBC, the Wall Street Journal, or others in the media.

Get on a regimen of a low-information diet.  Discipline yourself into reading or watching the news to 30 minutes a day or less.  Most news sources are businesses themselves and not a public service with your best interests in mind.  The sensational effect of most news articles and reports keeps viewers glued which translates to maximum profits for them.  Do yourself a favor and limit your daily consumption of news; only spend enough time here to keep yourself informed about what’s going on around the world.  Even better, try to limit your news consumption to non-profit venues like NPR or PBS.

Their broker or financial advisor recommended a particular stock.

Brokers and some financial advisors get paid commissions each time you make a trade.  If you use a passive strategy and trade maybe once a month (just to contribute part of your paycheck to your portfolio), then they’re not gonna make much money.  So there’s a strong financial incentive to push you to trade more frequently.  Don’t hate or blame them since that’s how their business model works; it’s analogous to getting your dog to guard your ham or a fox to guard the chicken coop.  Like the dog or the fox, your financial advisor or broker can only exert limited self control to curb their instincts to maximize profits for themselves even assuming they hold themselves to the highest ethical standards!

Now if your broker wants to remain in business and not be shut down by the regulators, they won’t recommend any random stock to you.  They will have (hopefully) done thorough research on the stock’s future prospects and determined it to be a good fit for your risk tolerance and overall portfolio and will likely have the data to back it up if you request for it.  They certainly want your portfolio to grow as long as it’s the result of their stock picks, otherwise you’d be bailing for a new broker soon.  But in reality, few investment strategies go as planned and often, your broker’s good intentions don’t necessarily pan out.

So What Do I Do About Asset Allocation Then?

Do your research on Lazy Portfolios, which require minimal upkeep over the years.  I will go into detail about this in future posts but for now, without knowing your particular situation and risk tolerance, I’d recommend looking at either the 2-Fund portfolio or the Permanent Portfolio to start.