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

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

75 comments — written on October 14th, 2009

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.

75 comments

Leave your own

1

October 14, 2009
iamamonkey

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

October 15, 2009
Concojones

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

October 15, 2009
craig

Actually I think your title should be “A good example of why I shouldn’t try to pick stocks”.
4

October 15, 2009
NomadicNeil

Has research not proven that it’s better to have monkey randomly choose stocks than the average professional advisor.
5

October 15, 2009
Mike P

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.
6

October 15, 2009
Ramit Sethi

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.
7

October 15, 2009
Justin King

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.
8

October 15, 2009
Ramit Sethi

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.
9

October 15, 2009
Trevor

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.
10

October 15, 2009
Oleg Mokhov

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
11

October 15, 2009
Ramit Sethi

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.
12

October 15, 2009
Greg Retzloff

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.
13

October 15, 2009
Steve Place

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.
14

October 15, 2009
Matt

Indexing is the way to go. Life cycle/target retirement index funds are generally overly aggressive for what people should want and feel safe with. If people would take the time to pick up one good book about the basics of investing (not stock picking or trying to find the best place to invest) they would understand the markets and how indexing can help them more than they could imagine. A target retirement fund accompanied by one additional bond index fund to lower their percentage of equities to something they’re more comfortable with would be excellent for most people. So many people out there are too scared to invest, or invest using active funds picked by their advisor, not by themselves. Those same people have no clue what they’re investing in, they just trust the advisor to do the work. If you want something done right, do it yourself.

It is beyond me how such a large population spends so little time researching about retirement. They intend to retire and spend 1/4 to 1/3 of their entire life in retirement, but don’t have the slightest clue as to what their invested in or how they’re getting to retirement.

I’m not trying to advertise here, so don’t even buy the book, just go to the library and read it for free. “The Boglehead’s Guide to Investing” was an incredibly helpful book. It took me from understanding almost nothing about investing, to feeling fairly confident about what I was doing. I got off on the wrong foot and started stock picking for a few months. After some research, I was glad to find this book and it made me realize my foolish choices.
15

October 15, 2009
Customers Revenge

I would call what you’re advocating to be “saving” not “investing”. Investing to me brings connotations that people know what they’re doing and are applying money towards something specific.

Saving to me is setting money aside for later. Regular deposits into funds are just a form of savings.

Example: You’re investing your time and money into your own businesses. Books, community, PBWiki, and whatever else. These are each specific and you hopefully get a hell of a lot more out of those businesses than out of a fund. When you get extra money from these “investments” that you can’t reinvest into your business or another business then you just “save” it by depositing it into your generic fund that does who-knows-what with it.
16

October 15, 2009
Trevor

Ramit, Agreed that Vanguard offers a good and lowcost option. I am not familiar with Schwab’s offerings in this area. As to your point that we both know people don’t rebalance – I agree as well, and offer as an alternative what some fund companies call Lifestyle or Asset Allocation funds. They allocate to a specific asset allocation and rebalance regularly to keep it there, and there are multiple options across the risk scale. The point in using them over Lifecycle funds is that you always remain in control of how much you have in equities, bonds, cash – and are not at the mercy of what the fund company thinks. If as an individual investor you are unsure over what your asset allocation should be, I recommend contacting a CFP and using them on an hourly rate basis – it will be a one time charge of maybe $500, well worth it in my book to get a professional opinion.
17

October 15, 2009
Matt

Customers Revenge:

The generic fund as you call it, invests in a variety of places. Target retirement funds generally have an index of the stock market, which invests some money in hundreds of different companies. GE? Own that, IBM? Own that too. The bond funds invest in a wide variety of bonds. You need to read the prospectus’ to understand where your money is going. Yet another example of someone who doesn’t research what they’re investing in. It is “investing”, you’re putting your money into companies with the intent to take a profit years down the road when you retire. Saving is setting money aside in a savings account, money market account, cds, or in the mattress. Putting money into stocks, bonds, etfs, mutual funds, and tips is investing.
18

October 15, 2009
Chris

Ramit, I agree with everything you say about 99% (or more) or people being bad at picking stocks. We may or may not disagree over whether that number should really be 100% – ie whether *no one* can actually be good at picking stocks. However, I do want to point out that if there *are* actually people who are good at picking stocks, then stories like this would be no indication of their skills. Results are always going to be distributed around some average. Just because it so happened that selling turned out to be the “wrong” move here doesn’t mean that it wasn’t actually the “right” move given all the information that was available to the stockholder at the time of decision. I’m a huge fan of making good decisions based on the information available at the time, and if it turns out to be wrong later then you can be confident that you would make the same decision in the same scenario again. It’s important to be information/decision-oriented, instead of results-oriented, IMO.
19

October 15, 2009
Snowballer

I think it’s like this.

Most people’s fortunes are tied up in highly specific investments which may not be a single equity security but are just as volatile.

For example, you go to graduate school for a degree. There’s a risk that in 10 years everything you learned will be obsolete. There’s also a “risk” that in 10 years what you learned will be more in demand in ever. You can look at what’s happening in that industry and the world in general, but you don’t really know. It’s analogous to buying a specific stock for X Y or Z reason; you are applying all your intelligence to making the best possible decision but you just don’t know in the end.

Similarly say you’re a professional such as a lawyer, etc. and you buy into a practice as a partner. Or you’re a mechanic and you buy tens of thousands of dollars worth of tools. Or you start your own company that does some kind of programming. All are very similar propositions in that you’re putting most of your personal worth into a single, highly specific basket.

That’s why, if I have money to invest over and beyond what it costs me to pursue my specific individual opportunities, I favor index funds and diversification. I am better off “gaming” my career and things I may actually know something about than trying to delude myself that I’m so damn smart I can pick all the good stocks. I can make more money for myself being a better professional Whatever than I can being a Cramer wannabe.

Honestly if I were so good at picking securities to trade for big short term gains constantly, I’d be a professional investor and I’d never tell anyone my methods or secrets. I’d spend all my time focusing on that and not learning to be a better dentist or whatever.

The thing is, my “career”, whatever it is, may fail. I’d rather bank on the likelihood that not everyone else is going to fail too, and own a little piece of everything. I simply have far more ignorance than I do knowledge (I haven’t even read the entirety of the local public library for example), and diversification and passive investing are good strategies for protection from my own ignorance.

And for that matter the smartest person on earth is more ignorant than he is knowledgeable. There’s just too much to know.
20

October 15, 2009
matt

meet with a local primerica representative and have them help you with your money. costs you $0 and it was the best decision i’ve ever made. I now know how to invest my money and how much I need to invest a month to retire when i’m 50. Buying individual stocks is a joke. buy mutual funds. If the stock goes down, who cares, you are buying shares on sale. I’m amazed at how complicated people try to make investing
21

October 15, 2009
Ben

Primerica?!?!?!?! Please tell me you are kidding. There 2 HUGE things wrong with that company.
1. All of the products they will be suggesting are what the financial rep makes the most commission on which is obviously never what ideally you should be investing in.
2. Their reps maybe have a college degree but most likely just a high school diploma or GED. My cousin who is a loser high school dropout got a job as a rep for them as a financial advisor. Several other people I know that didn’t have the grades to make it into business school also worked for them as well. I would never trust my investing to someone that couldn’t even graduate high school.
22

October 15, 2009
matt

@Ben
The commission is based solely on the amount invested and has nothing to do with which stocks/funds you invest in. You’re terribly misinformed. I bet you have whole life insurance rather than term too. Why would Primerica be the one company that didn’t need bailout money? I’ll be waiting for your answer
23

October 15, 2009
Matt

@Matt

What is Primerica’s comission? What percent? Do they take it yearly, or when you invest the lump of money?
24

October 15, 2009
matt

it is based off of how much you invest, so each time you invest they get a small portion. I put in $10,000 and my rep got less than $50. Their salaries are all available on their website, there are no secrets.
25

October 15, 2009
Matt

That fee is very reasonable, but what kind of funds did they put you in?
26

October 15, 2009
benbleikamp

What do you say when people bring up Warren Buffett? He seems to have a knack for picking out great companies and going “all in” by buying a controlling stake in them.

He actually had a great quote, though I don’t remember it exactly, but essentially he said “The difference between a professional investor and an amateur investor is a professional knows when to put all his money into one stock.”
27

October 15, 2009
matt

@the other matt
they don’t charge me a penny (primerica itself) The funds I invested in are van kampen. I’m never charged by primerica to invest only by the mutual fund company which is a very minimal charge
28

October 15, 2009
Paul E

@matt “Why would Primerica be the one company that didn’t need bailout money?”

from wikipedia: Primerica Financial Services (PFS) is a direct marketer of financial services which uses a large sales force of full-time & part-time representatives, headquartered in Duluth, Georgia. A subsidiary of Citigroup

A subsidiary of Citigroup. LOL, What was that about no bailout money
29

October 15, 2009
Ramit Sethi

Ben, that’s a GREAT question with a pretty complicated answer. Reading books like “The Snowball” or “Poor Charlie’s Almanack” (both awesome books), you can start to get a sense for why Buffett/Munger are different. My basic response is: They are extraordinarily rare exceptions to the rule. Just as you wouldn’t use Michael Jordan as an excuse to drop out of college and go into basketball for a career, you wouldn’t take the extremely small number of individual investors who’ve beat the market over the long term and try to emulate them — especially when the data quite clearly indicate that virtually nobody can do so (yet people repeatedly believe they are different).

A couple interesting links:

The Other Reason for Warren Buffett’s Success: Why Warren Buffett gets special deals + how it’s impossible to determine his actual return % of investing alone. Very interesting.

My links on Warren Buffett. Lots of stuff, with my notes, here.
30

October 15, 2009
matt

@Paul E – Primerica was not a part of the Citigroup bailout. Primerica has more than $5 billion in capital and zero debt. Check your facts again
31

October 15, 2009
JP

You guys should google an article that Warren Buffett wrote called “The Super Investors of Graham and Doddsville”, then check out fwallstreet.com. Some interesting reading in there about picking your own stocks vs.investing in mutual funds.
32

October 15, 2009
Will Ashworth

Read this article. You’re probably better off buying stock in the fund companies themselves. JMHO.
http://stocks.investopedia.com/stock-analysis/2009/Winning-The-Target-Date-Fund-Battle-TROW-MFC-AB-PFG-WFC0605.aspx
33

October 15, 2009
Robert

But Jim Cramer said it was a good stock…
34

October 15, 2009
Jim

The article should read “Why it’s good to pick individual stocks!” It’s never a mistake to walk away with a 500% gain. Tell me the last life cycle fund to return that – well, probably not in their life cycle!
35

October 15, 2009
Mike P

One thing to consider with the professional investors is that many of these guys cannot move money without it being noticed. Nobody is going to notice if you hop onto Scottrade and buy 2 shares of google, but when you are moving large amounts around you have to buy the shares in blocks. The buying pressure (or selling pressure) gets noticed thus modifying the price. I would consider this as something that can limit your returns.

For the individual I would agree that Lifecycle or Index is the way to go because individual stocks require that you do alot homework and due diligence, not only so you understand what you are buying but also because there is a lot misinformation purposely put out there to try and influence the market. For myself I feel that I am willing to step up to the plate and do these things but I also can recognize the risks involved and I keep stocks no more than 5-10% of my total investment portfolio. I wouldn’t consider myself a great stock picker but my returns have been decent and I feel that I have gained a tremendous amount of knowledge in the process.
36

October 15, 2009
Andy J.

My 1st comment, but I’ve been a consistent reader for a couple years. Great blog Ramit – it’s been helpful and inspirational to me.
—–
I love it. Please continue to believe that the efficient market hypothesis is true and that over the long run no one can beat the market. Ignore every value investor that has been successful thus far and continues to be successful in their career: Warren Buffet, Benjamin Graham, Seth Klarman, John Paulson, Lee Ainslie, Dan Loeb, David Einhorn, Stephen Mandel, and the list goes on.

Ramit – you really are doing the right thing. 99.9% of people can’t pick stocks in the long run, so the vast majority of people shouldn’t be trying. Indexing is a great way to get exposure to the US equities market without actually having to put in the work to squeeze out a few extra percentage points. I am a professional investor and fundamental value investing is hard work. There are things I do and resources that I have that no individual investor can replicate to make it worth their time nor capital. I work 80 hours a week learning about entire industries and each of their competitors. I interview management teams to assess their capability. I go to industry conferences to get insight into upcoming trends. I speak with consultants and experts in the field to cross-check my own knowledge, management’s comments, and investor expectations. All of my colleagues went to top tier institutions and have tremendous cognitive ability. When it’s all said and done, there’s no guarantee that the stocks that I am responsible for will make money. But – multiply this effort by a couple dozen people across other industries and you have the ability to see opportunities throughout the market.

Not to make fun of the paper-napkin idea generator, but thinking of 5 reasons to buy or not to buy a stock is pretty easy and took 5 minutes. That’s top-down investing, and there are so few people in this world that can do that consistently (Stan Drunckenmiller for example) and really that’s better suited for industries rather than individual stocks. It’s also quite dangerous when talking about technology stocks, but hey even some individuals have a better ‘gut’ about technology trends than Wall Street.

All that being said, I still think it’s good for the individual investor to be involved and interested in the markets. While a large institutional investor has a lot of advantages, they also have a lot of disadvantages. They move slowly and move markets. They can’t concentrate all the capital into the best ideas. Some have a shorter time horizon for investments – ie. if it won’t work in the next quarter or year, then it’s not investable. They have to go through layers of management to actually buy or sell anything of size. There are restrictions and the size of the company that they can invest in. Some are *required* to own (buy) certain companies. All of these things add up to the possibility to have equivalent or even greater performance than professional institutions. So, can outperformance be done? of course. Is it easy? of couse not. Is it worth the effort? Up to you.
37

October 15, 2009
Financial Samurai

Everybody has a success and failure story. I believe you SHOULD pick stocks if you’ve done enough research. It’s basically positive percentage gambling.

I’ve made $150,000 on one stock before and I’ve lost $35,000 on one stock before. Sucks losing, but if you can win 60% of the time, you should continue to do it always.

Financial Samurai
38

October 15, 2009
Michael

Your life cycle funds ‘advice’ is very dangerous advice in general.

This is another tool used by fund companies to coax you to their funds. Life cycle funds, even in the most conservative investments have lost money in the most recent stock market flop (think bonds, but getting stock results). This is a minor scandal comparatively, due to the small amount of ppl and money in these funds compared to the whole market meltdown, but I’m sure those that took them for the ride are quite livid at what they were ’sold’.

Your advice panders to the fund companies out there and due to the newness of the these devices, all their flaws are unknown, until now, with the cracks becoming more evident.

Every investment has it’s pros and cons, but choosing laziness (life cycle funds) as an investment, you get less than advertised returns as a poor payback.
39

October 15, 2009
Greg Retzloff

Using a lifecycle fund doesn’t indicate “laziness,” nor does suggesting that a young investor use one consitute “pandering.” In fact, lifecycle funds may be the best solution for a large minority of individual investors who have better things to do than obsess over the minutia of investing. They may be the best choice for others who would not to invest at all if not for the simplicity of lifecycle funds.

Assuming an investor chooses either Vanguard or Price, there is one caveat in using these funds. An investor shouldn’t pick a fund because of its “target date.” Instead, the decision of which fund to pick should be based on the risk tolerance of the individual investor. The choice of a fund and its bond composition will reflect this risk.
40

October 15, 2009
Mark Wolfinger

Life cycle funds may be an easy choice, but they represent a very poor choice. The data is available that shows these guys a) don’t stick to their portfolio restirctions and b) had a very poor year in 2008.

Investors can do far better than that. And deserve better. Just because you recommended these in your book does not mean you cannot supply better advice now.

I am not suggesting that they pick individual stocks. I am not suggesting anything specific, other than your recommendation was ill-advised.
41

October 15, 2009
Matt

@Mark

Did poor in 2008? Please tell me what funds did do well in 2008. The market crashed, most everybody took a big hit, including warren buffet on his GE purchase. You can’t even attack target retirement funds directly, they are made up of underlying funds. I still recommend target funds that have a % in bonds close to what the investor desires rather than the date printed on the fund.

@Jim

No life cycle/ target retirement fund has returned 500% in a short time, but no such fund has made anyone’s money disappear either. That is unless of course they were investing in some ripoff “advisor” or company like Mr. Madoff. The idea is not to make a quick buck here, but rather to invest and earn money and preserve capital. The goal is retirement, not a get rich quick scheme. Most people have no clue how to pick stocks, and those that think they do have probably gotten lucky. There are those few exceptions. If you’re all so good at picking stocks and making money, why do I not see you on TV with Warren Buffet? After all, stocks can get you 500% gains. Just pick a couple of good stocks and gamble, (Invest if that’s what you want to call it) and live like a king.

@Financial Samurai

How do you know if you can win 60% of the time until it’s too late?

My whole point here is, why take on a ton of risk when you can safely put away money into index funds and get yourself on a set age that you’d like to retire. Picking stocks is gambling at best. Very few people have continually made significant money picking stocks and will continue to do so for years. Somehow I’m guessing none of them are any of you. If you’ve ever seen any studies of human psychology, most people think they’re better than the next guy. Statistically, you have a 50% chance of being better or worse than the next guy. That means a lot of people have thought wrong. Who has enough time to research and pick out the winners from all the losers? Why not take the safe route, know what you should have at retirement and worry about enjoying life?
42

October 16, 2009
JimE

Andy J,
That was a great comment about institutional investment vs personal investment.
My only comment on “investing” is that if you do it without goals and a realization of your own circumstances vs the average you’re an idiot. If a young couple starting out received a gift of 100-200k (someone dies, they both have college funds but got scholarships, home downpayment fund from parents) they do not have the same risk for retirement as a young couple starting out with 200k in student loan and CC debt. The first couple can basically invest in CD’s Treasuries and low risk bonds to try for an average of 5-6% annual return and guess what, they will retire with 2-3 million. No need to go for the 8% annual return that wall street promises.
I know people that have this and it kills me, if you start off with a small nest egg in your 20’s please realize what an advantage you have. Its like the 55 yo with 800k in a nest egg 80% invested in stocks but people don’t realize this because they think it’s so far away.
43

October 16, 2009
Steve

As I’m sure most folks realize, one size does not fit all. I prefer to do in-depth stock analysis and pick my own stocks. I do rebalance, keep a mix of safe, slightly risky, and risky investments (stocks, bonds, etc.), and keep my emotions out of it. I do this because I like the control and I simply don’t believe that financial advisors are worth the money people pay them. This strategy has worked well for me over the years. Straight lifecycle funds will work for others.

This post illustrates (perhaps unintentionally) one tenet of buying and selling stocks: You can’t time the market. You can never know for sure when to get in or get out. “I wish I had held it,” or “I wish I had sold it,” or “I wish I had bought it” are things every stock buyer will say. Just get over it. The guy made 500% which is a phenomenal return. Too bad about the additional 500% but honestly, he’s way up. Who cares if he missed out? If you think you “lost” on a 500% gain you should spend some of the profits on a psychiatrist.
44

October 16, 2009
Customers Revenge

Matt: You said

-It is “investing”, you’re putting your money into companies with the intent to take a profit years down the road when you retire. Saving is setting money aside in a savings account, money market account, cds, or in the mattress. Putting money into stocks, bonds, etfs, mutual funds, and tips is investing.-

Investing to me implies more control and intelligence than putting money regularly into an instrument. To me a fund is not much different from a savings account. You maybe could invest into funds, but I guess that most people just save and keep their savings partly in funds.

JimE is right on. I once commented on this site and was lambasted for saying that risk is for the old, not young. It is a twist on the opposite common advice, but the point is that if you start young then you don’t need to take much risk to find a distant retirement. If you’re old before your start then you have to take much greater risk to do it.
45

October 16, 2009
Nelson

Just to be clear on this, you’re using the example of a 500% gain to tell people to not invest in individual stocks? The underlying argument has merit, but the example is just terrible.
46

October 16, 2009
Bobby

Hey, he made his money, no harm done. Sure, he could’ve made more, but if the rabbit wouldn’t have stopped the dog wouldn’t have caught him. No crying over this.
47

October 17, 2009
Aaron

Ramit,

I read your book and I have been struggling with this chapter. Most index funds don’t have any real ROI over a long period of time. Can you give me numbers to prove otherwise? I also cannot figure out this magical national average of 8% returns. Where does this come from.I kinda like buying a stock cheap having it rise 500% and then selling it. Sure it’s more risky but so is having money in an index fund for 10 years and not really gaining a profit.
48

October 17, 2009
Justin King

Aaron, just to jump back into the conversation here. Remembering back to Finance class, the 40 year average (which, I believe was 1964 – 2004, give or take a couple of years), was just shy 10% on the S&P 500.

I don’t know about the 8% statistic.
49

October 18, 2009
Snowballer

John Bogle’s “The Little Book of Common Sense Investing” does an excellent job of citing the numbers about what kind of return index funds historically have (whether the investment is held in tax free space or not makes a big difference).

It’s ridiculous to even say ROI on an index fund is zero because that implies that the net economic value provided by every company in the index in question never changes. It is to say that the companies work in such a way that every single advance in technology, management, new products, cost cutting measures etc. is somehow canceled out. Of course I suppose it depends on where you take your numbers from but I’ve never seen any research to support that. If anything the research indicates that indexing provides a modest real return over time (the problem being that “time” is forever and we don’t live that long which is why the recent crash was such a disaster because too many people had too much in equity, but that’s why asset allocation is important).

Granted he is a biased source but he does cite lots of facts, so there you go.
50

October 18, 2009
Important News - Oct. 19

[...] 17) A good example of why you shouldn’t try to pick stocks [...]
51

October 18, 2009
Nick

I have to commend Ramit on his take of the blog in question. Although my intent was more focused on showing an example of how a company defied projections and conventional wisdom, overcoming huge obstacles. I will say it shows a lot about how the predictability/or volatility in a single company can create problems in predicting long term growth.

In the end my take-away from Netflix was there’s just no substitute for great management who knows their business. Though, I think I’ll leave the stock picking and suggestions to people like Ramit and focus on my core competency of Branding and Product Management.
52

October 19, 2009
lurker

Netflix advice was bad. Since you can’t predict the direction of stocks, the correct move was to put in a trailing stop and let the market take you out or let your profits run as you raise your stop under the rising shares…of course, the art is knowing where to put the stop so you aren’t sold out right before the share double again…but it still would have been better advice than studying the “fundamentals” as the price trend of the shares is more important.
53

October 19, 2009
Kevin

Wow. There’s a ton of bad advice and misinformation in these comments. I just wanted to clarify a couple of things.

1.) No amount of intelligence, education, experience and research will ever enable you to consistenly pick winning stocks. There’s no such thing as a “good” fund manager who is skilled at picking winners. There are lucky ones, and unlucky ones. That’s it. Anyone trying to convince you otherwise has an agenda.

2.) Primerica is an MLM pyramid scam. Do not let them anywhere near your money. Their representatives are not hired, they’re “recruited.” They don’t receive a paycheque, they receive paltry “commission” cheques, and they paid Primerica for the privilege of working for them. Their products are outdated and grossly overpriced (they have to be, in order to pay commissions to your rep and the 7 people in his “upline”). Let’s not waste any more time discussing this joke of a “investment company”.
54

October 19, 2009
Ramit Sethi

Good advice, Kevin.
55

October 20, 2009
Evan

“With the knowledge they had, it could have easily lost 500% also.”

Uh… no. It could not have, under current US corporate law. This math… it is not my kind of math.
56

October 20, 2009
Ramit Sethi

HAHA
57

October 20, 2009
Joel

So let me get this straight: “This guy made money on a stock, but he could have made a lot more if he’d stayed in. Therefore, you shouldn’t buy stock.” This example proves the contrary.

The point of investing in the market clearly isn’t that you’re going to make money every time, guaranteed. The point is that you can do better, over time, if you make smart investments.I know “smart investments” is a big caveat for people who don’t have hours to devote to studying the market. But if someone does their due diligence, and they’re judicious, they could do pretty well.
58

October 20, 2009
Ramit Sethi

Agreed that investing means you need the stomach to handle volatility, but that’s not the point of this post.

The point is you can’t time the market, and even if you spend every day with a serious staff backing you, odds are extremely, extremely good that you won’t even equal the return you can get with a low-cost vanilla index fund.

I know we love to believe that “try harder=win,” but that’s simply not the case with investing for 99.999999999999999999% of people for structural, behavioral/psychological, and competitive reasons.
59

October 20, 2009
Joel

I’m pretty new to your site, and I see you’ve written some about investor behavior/psychology. That’s a really interesting element to add to the subject here — I look forward to seeing how psychology impacts people’s decisions here. Can you recommend a particular post that addresses this?

Thanks for the response, too.
60

October 20, 2009
Ramit Sethi

Sure, see my investor-psychology blog posts and bookmarks on psychology and investor psychology.
61

October 20, 2009
Credit Card Chaser

I agree, a great read on this subject is “A Random Walk Down Wall Street” by Burton Malkiel – its a classic.

http://en.wikipedia.org/wiki/Random_walk_hypothesis
62

October 21, 2009
xmasy

Ramit,

Would u ever reveal ur net worth?
63

October 21, 2009
Nate

This anecdote is an indictment of stock-picking? No, this is an example of hindsight, which is best left out of any serious investment program. 500% is a nice profit, and without a crystal ball, this was a good move. Sure, he could have let his profits run as the old saying goes, but he could just as easily have lost money by holding too long. There are always new investment opportunities somewhere.

I don’t see how buying the average of 500 or more businesses, some of which are poor, some mediocre, some good, and some great, constitutes “investing.” Any serious investor would look at things like credit quality, dividends, earnings, valuation, etc, and decide how to allocate capital in a way that will maximize returns while minimizing risk.
64

October 23, 2009
xmasy

I agree with Nate.
Ramit, sometimes i do wonder if u are credible enough to say what u say?

For example, can u show us what u make etc, and where that money goes and how its invested and so on. What are your exact sources of income and so on.

We all talk greatly about Warren Buffet because his assets PROVE it. If he was dirt poor, his name would never be mentioned.

Basically what I am asking u is, can you show us how you became ‘rich’ or trying to by of revealing your own financials. Is that a fair request?
65

October 23, 2009
Bob Schumann

I agree – investment is NOT about picking stocks.
Do not believe the myth that diversification can be achieved with 10-30 individual stocks. Academic research indicates that it takes at least 60 randomly selected individual stocks to eliminate 88% of diversifiable (uncompensated) risk. I say, build a $250,000 core portfolio with low cost index funds or at least 60 individual stocks from different industries and countries.

Bob Schumann,
CFP, People’s Financial Advisor
66

October 24, 2009
Steve

I’ve got a quick question for those that are keen on purchasing funds instead of individual stocks. I’m not trying to be facetious here. I’m really looking for some insight.

There are a vast number of stocks on the market. There are also a vast number of funds on the market. Many more funds than stocks I imagine since you can slice and dice a fund with any number of stocks.

So the question is this: If it’s difficult to choose individual stocks, isn’t it even harder to choose a fund? I am assuming that funds are selected on the same basis as stocks (good management, past performance, risk vs. reward, etc.).

As I see it, the only “fund” that would work is an index fund with no management fee taken off the top. Anything else and you’re “gambling” just as much as you would be on individual stocks.

Any thoughts on that would be appreciated.
67

October 24, 2009
Bob Schumann

Brinson, Hood & Beebower research of 1986 proved that asset allocation is the single most important decision that an investor makes. Over 90% of portfolio performance is explained by the asset allocation decision.

With this in mind, you can see why picking index funds or mutual funds with lowest management fees is a direction you should adopt as long as they fit your overall asset allocation strategy.

Bob Schumann,
CFP, People’s Financial Advisor
68

October 24, 2009
Steve

Bob:

This is still not clear. How does this affect choosing a fund? Ultimately, it is the individual investor who must select an allocation strategy and choose a fund. To me, this seems to be just as much work as selecting several individual stocks that suit your risk level. Choosing mutual funds vs. picking individual stocks would seem to be a wash to me. In both cases, the individual must be aware of the same fundamentals and make the same (difficult) choices.

As for choosing a fund with 60 or more stocks, this doesn’t seem to make sense to me either. At that point, you are merely tracking the market. As you stated, “randomly” selected stocks eliminate risk. If this is truly the case, there is no point in picking any type of mutual fund. Simply jettison your advisor and their fees and pick an index fund if you want diversification, no (not low) management fees, and a reasonable return.
69

October 27, 2009
J

Just don’t go blindly following your appointed, well-intentioned guru.
70

October 30, 2009
Customers Revenge

Academic “proofs” about the best strategy START with the assumption that you can’t pick stocks! They ASSUME that everything is random, that the market is efficient and that stocks have certain measurable statistics. Of course the result that comes out is going to be how to pick a set of randomly behaving objects about which you know some statistics like volatility and correlation.

There are other proofs that the first proofs are wrong (see Nassim Nicholas Taleb Fooled by Randomness). Stocks and markets are not statistically normal so all those proofs are roughly useless.

There is also the common sense, undeniable, reality that stock represent businesses. If you can’t know which way a stock will go then you can neither know whether a business will succeed or fail. But that’s a crock because there are many many successful businesses and serially successful business people.

The real answer is that, given a list of three letter SYMBOLS you can’t do better than portfolio theory. Even given news and financial information, most people can’t pick well. But then again, most people can’t hit the basket from the foul line or sink an 8 ft putt, yet there are others who make millions doing just that.
71

November 8, 2009
trevor

You can pick stocks and its not hard to do so. Just because most people can’t does not mean that you can’t. Its actually quite easy if you have the right temperament and you know what you are doing. The reason Wall Street experts are horrible at it has nothing to do with its difficulty and everything to do with the demented ways in which Wall Street and finance work.

Your post should really be titled “An example of why you shouldn’t speculate”

Their are many problems with the NetFlix example given. Firstly and most importantly: price, price, Price, PRIIIIIIIIICCCCCCEEEEE. You never even consider this. I don’t mean absolute price. I mean price relative to book or earnings. I check the history of this stock and it appears that at the time your friend bought it (2003 or 2004) the p/e was most likely at least 30 if not more. Also the earnings history was basically crap. Based on price and earnings history we can classify this as not an investment but as pure speculation.

Your analysis of Netflix is also an example of pure speculative reasoning. Every factor you considered was some speculation about what might happen in the future and how it might effect the stock price. You never considered the financials of the company. Companies like this, unless they are very very cheap almost always represent speculations. Netflix has a new business model, it does not have a long history of positive earnings, it has no dividend and it trades at a ridiculous price given its financials. I would never even consider this stock as an investment unless it traded at a ridiculously low P/E (like maybe 4-5).

How do you invest? You buy solid companies with a business model you can understand (simpler is better) with long stable positive earnings history, good dividends, low leverage, excellent profit margins, great return on equity. Its also good if the company has a monopoly, sells a product with a solid brand or has some way of obtaining economic rents. You want a business where there isn’t a need for large capital expenditures. And most importantly you want it cheap. I prefer stocks with P/Es of around 10 or less. If the price is cheap enough I will buy almost anything including Netflix and even Enron. Price and quality are the key factors. Even if the quality is low, a stock might still be a bargain as long as the price is cheap enough.

@Customers Revenge: Nassim Nicholas Taleb is an idiot and his book is garbage.

@Bob Schumann: Asset allocation is absolutely ridiculous and I don’t believe in it. Many of the greatest investor including Buffett never even consider it. As for diversification, if you don’t care about volatility (you shouldn’t unless you have large upcoming liabilities) then you don’t need to eliminate all diversifiable risk. Oh BTW, I think CAPM is a load of crap. Investors do no get compensated for holding large beta stocks.
72

November 8, 2009
trevor

@Kevin: I think you are completely wrong. Fund managers are not just lucky/unlucky. Buffett has real skill not just luck and there is proof of it. Read the following:
http://www.conscious-investor.com/articles/news/conference/iwif.pdf

There is a 1 in 100 billion chance that Warren Buffet could have obtained the result he did. There are not 100 billion fund managers. Therefore its highly improbable that Warren Buffett’s performance is the result of chance. BTW, the 1 in 100 billion result is obtained from the fact that Warren has beaten the S and P 42 out of 47 years and we think of each year as a coin toss (head you beat S and P and tails S and P beats you).

I will anticipate your defense: Ah but Warren Buffett gets special ‘deals’. Warren Buffett was making a lot more money when he first started out and wasn’t getting any special deals. In the 1950’s when his portfolio was under 1 million he was making 50%-100% returns. And he has stated himself that size is the enemy of performance. Also if the special deals argument is true that why don’t other fund managers get special deals and also outperform.
73

November 8, 2009
Ramit Sethi

Heh this line says it all: “Asset allocation is absolutely ridiculous and I don’t believe it.”

Okay then, I see. Just pick really good stocks and have the right “temperament.” Then “its not hard to do” and “its actually quite easy.” Simple! Everyone can beat the market!

Oh wait…
74

November 8, 2009
Steve

I’d have to say that I agree with Ramit’s assessment. Asset allocation does matter (you don’t want to be overweighted in a single asset class or sector).

As for stock picking, I’ll just say there are two choices:

You can go with an index or lifecycle fund and put your earnings on autopilot. This is Ramit’s philosophy and it is a good one (particularly if you can start early).

You can also go out and do the serious legwork required to find a mix of stocks that offer a better return. It is “easy” in the sense that anyone can learn how to do this. All you have to do is learn some technical analysis and research the companies.

It is not “easy” in the sense that you can be on autopilot or just learn a little technical analysis and spend a few minutes reading annual reports over a few beers with friends to pick a winner. You must do the WORK to get the better return. Most people have no interest in doing the WORK or realize how much WORK is required to get the better returns. Most people don’t like WORK and that’s why “no one” beats the market. That’s fine. Get the index fund or get the lifecycle fund and get on with your life.
75

November 11, 2009
Vas

It depends if you have the time or not and actually enjoy and have an interest in doing the research and risk analysis. If this is all to hard then a lifecycle fund is a much better option. If you plan on doing it yourself – your finger must be on the pulse constantly. If not losses will incur.