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.

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…

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.

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.

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.

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.

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

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.