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A good example of why you shouldn’t try to pick stocks

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This is a great example of why you shouldn’t try to pick individual stocks.

Just because you can write down a top-of-mind analysis on a napkin doesn’t mean you understand a company’s financials. And remember, most professional investors — who are paid millions of dollars per year — can’t either. Investing is not about picking stocks. TELL YOUR FRIENDS THIS.

My Prognostication Failed

“Five years ago I had a friend who was sitting with Netflix stock which had increased in value by 500% when he came to me and asked for some advice: Should he sell? My response was yes based on the following criteria.

Strong Competition– Blockbuster had recently entered the fray; they had a strong competitive strength with their local stores and had plenty of money to target Netflix. I figured even if Netflix did win the costs associated with acquiring and retaining subscriptions in a competitive atmosphere would erode substantial earnings.

Digital Transition– At the time 5 years ago many were predicting a strong push to web based content delivery. It made a lot of sense and would have an impact on Netflix. Expectations were that strong players like Microsoft, Google, Sony, and Apple would crowd out Netflix.

Content Acquisition– With the digital transition I expected consumers to transition to watching web video. As such, companies interested in this market would need to negotiate new deals with the film companies. The Netflix model is somewhat disruptive and they lacked strong relationships with the film companies. This would require a hurdle that Netflix would have to overcome, which introduced substantial risk.

Increasing costs of doing business– Netflix’s primary model was based upon delivery by mail, the more customers used the service the more expensive it would become. Additionally the US Postal Service had shown an interest in continuing to increase the cost of shipping.

Business Transition– Netflix was looking to radically change their business model from mail delivery to digital delivery. It was unclear they had the Intellectual Property, or business assets to smoothly make this transition.

While these were all valid concerns at the time, Netflix has been validated. My friend sold Netflix around $10, and it’s now hovering near $45 (yes up another 500% from where he had it).”

It continually enraged me when individual investors think “investing=real estate” or “investing=picking stocks.” Even worse is when this lie prevents people from ever investing in the first place because it’s too complicated.

There is a simpler way: lifecycle funds. I cover this all in chapter 7 of my book, including picking long-term investments, automating investing, and various investments based on your appetite for risk.

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75 Comments

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  1. So true. Just as you wouldn’t expect a casual programmer who programs 1 hour a week to compete with the full-time big shots in Silicon Valley, you can’t expect your average retail investor to have the time and resources to pick stocks well.

    Oddly enough, however, your friend made the right decision to get out of Netflix. There was no real reason to have a position in that one stock. With the knowledge they had, it could have easily lost 500% also.

  2. While I agree stock picking is over-rated, I do see some value in it. I buy a stock as a proxy for an index. The advantage is that you can follow it up and buy when it’s lagging the index. I admit it’s tricky* though, not for the average investor, and my results so far aren’t the greatest. I’d say it’s for those who think they can compete with the pro’s, and are happy to invest a lot of time, too.

    (*) Tricky because very likely, you are judging the stock by exactly the same criteria as the rest of the market. In order to have a competitive advantage, you need a different perspective. That must be why this guy’s well-motivated Netflix advice turned out to be worthless.

  3. Actually I think your title should be “A good example of why I shouldn’t try to pick stocks”.

  4. Has research not proven that it’s better to have monkey randomly choose stocks than the average professional advisor.

  5. If you are in it for the long term than investing in equities can be a good component of your portfolio. People get burned by trying to game it for the short term or buying a stock on the advice of someone else and not understanding the reason. I can’t argue with your statements about Netflix but it may have been helpful to look at things like growth rates of revenue, EPS and such. Plus 500% return is nothing to laugh at, so I would have sold also just to lock in the profit.

    • Oh, equities are important. I’m just saying you — and I, and nearly everyone — are not good at choosing them. Each of us loves to believe we’re “different” than those other stock pickers, but when we do pick stocks, we similarly fall prey to several cognitive biases and structural failings.

  6. While I fully understand the value of investing in index funds, the logic is a bit off with this and I think a lot of investors inherently know it.

    Looking at the S&P500, there are companies on the rise, companies on the fall, and companies staying the same. I’m talking about performance here, not stock prices. Naturally, we want to invest in the companies on the rise. I hear the random walk argument that a stock is a stock, but that is obviously false (keep reading).

    To me, an Econ grad, investing is about stock picking through a diverse portfolio. Of course, this assumes that you’re actually putting effort in and not going off gut feelings.

    Crunch the math (long-term debt, EPS, P/E, growth rate, ROI/ROA etc.), look at the micro and macro environments, and then make the best judgement possible. Realize that sometimes you’ll be right, sometimes you’ll be wrong, and either way let it go. Regarding this post, my complaint isn’t with the guy saying sell Netflix – it was a good judgement on an already phenomenal return – but with him feeling silly enough to write the article.

    An interesting thought, VC firms do not invest in “just any start-up” that comes along, nor do they take the 500 biggest start-ups. They invest in the ones that make the most sense from a business stand point.

    So why invest in public companies any differently?

    If you’re lazy, go index. If you don’t care, index (mattress?). If you don’t have enough cash to properly diversify, index. If you don’t know how to read a financial statement, index. Otherwise, if you’re fully knowledgeable I gotta go with picking for the long-term as the better strategy.

    • Justin, I’m not trying to make one measly book sale here, but please read Chapter 7 of my book. I show that the idea that being “fully knowledgable” is not a good reason to pick individual stocks. There are countless examples I cite that illustrate this — and not just for random people, but “experts” who are highly paid to do this all day long.

  7. Ramit, as a personal financial advisor (Long-time reader, first time commenter), I have some serious concerns with your recommendation of Lifecycle Funds. I’m not getting into the indexing vs. picking stocks, or even actively managed funds argument here. But, Lifecycle funds, as they are currently constructed have some serious flaws. First, they are not standardized as to asset allocation. Funds with the same “Target Date” will have vastly different amounts allocated towards equities at any given time. Second, many lifecycle funds use underlying actively managed funds, defeating point of using them for indexing. Some use index funds, and some also combine the two, which is even crazier. Third, there remains a wide range of expense ratios among the different fund companies that offer index funds. My point is that is not as easy as saying, “Use a Lifecycle fund, and you dont ever have to worry about it again.” If you believe in the indexing argument, then I would recommend doing a bit of research to determine your own asset allocation and then buy the index funds to fill it out. Don’t tack on another layer of fees just to have someone manage your asset allocation of index funds, which is what you do with a Lifecycle Fund. Either way, I agree that stockpicking is not advisable for most “Do it yourself-ers” – I just don’t think Lifecycle funds are the golden ticket they have been marketed as.

    • Thanks for the thoughtful comment, Trevor. I agree that there’s some disparity in lifecycle funds, but of the best ones (which I specifically name in my book, including Vanguard and Schwab funds), the fees are extremely low. Yes, you need to do a little homework to determine the right asset allocation. But picking a quality lifecycle fund is far easier and more effective than indexing to a target asset allocation because, as we know, people simply don’t rebalance. Granny should have never lost 35% of her money, for example.

  8. Hey Ramit,

    80-20 investing with lifecycle funds.

    I had planned out my entire personal finance system… except for one thing: investing.

    Investing was the one hole I wasn’t looking forward to plugging (that’s what she said). I knew about mutual funds, but even with those, I’d have to take care of them. I wanted something where I buy once and it runs on itself. I trusted the system much more than myself with this stuff.

    So imagine how excited I was when I was approaching the end of your book. Lifecycle funds – EXACTLY what I needed. An 80-20 solution to investing. I’d spend the 20% buying the lifecycle fund and get 80% results. Plus I only have 3 choices, which is great: Vanguard, T. Rowe Price, or Schwab.

    Thank you so much for exposing me to lifecycle funds in your book. Thanks to you my personal finance system is complete. It was EXACTLY what I needed.

    Here’s to maximizing personal finance by 80-20’ing it,
    Oleg

  9. There’s a common misperception that “the pros” beat the market. Most don’t in the long haul. Academic reserach is solid on this.

    Two of the most celebrated funds of the last 30 years, Fidelity Magellan and Legg Mason Vaue Trust, have lagged Vanguard’s S&P 500 Index by 2% or so over the last ten years. Check Morningstar’s tax-adjusted return figures to verify.

    Lifecycle funds from Vanguard or T. Rowe Price are an excellent way for the newer investor to get started. An investor can use these as a “core” investment and then further diversify with an REIT, a good commodity-related fund, short-term bonds, and so on.

  10. Yep. Picking stocks is not investing. It’s speculation.

    You can make money from speculation, but it has more to do with risk management and discipline rather than getting some long shot homerun and retiring on that play.

    But buying a stock because you believe in the company is a terrible way to go about it. Men with Deep Pockets will make you look very, very foolish.

    Also, I’m not sure if I agree with using lifecycle funds, but Trevor did a pretty good job of hashing out the arguments.

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