The Next Big Thing
At some point or another we’ve all heard our neighbor or a distant relative talk about how they have invested in some obscure stock that is making them a small fortune. This often leads people to invest in that same stock so that they don’t miss out on the ‘next big thing’.Of course, we all would have liked to have invested in Amazon when it was just a river in South America. But finding those stocks that will eventually become the big winners down the road is not easy. Very often, those hot tips don’t workout very well. In fact, they may even leave some individuals with a bad experience that turns them off of investing all together.
So Many Stocks, So Little Time
There are several challenges that come with investing in single stocks, or what is commonly referred to as ‘stock picking’. For starters, rather than just relying on your neighbor’s word for it, it helps to be able to know something about the business you are investing in. This includes everything from its recent track record to its outlook for the foreseeable future. In fact, there are professional analysts that do this for a living. And these analysts usually have years of experience in doing the work that they do. This is known as fundamental analysis and it requires a deep knowledge reading and interpreting financial statements. Clearly, most of us do not have those skills.
The process of fundamental analysis can be very time consuming. Aside from doing the initial work to understand a business well, there is the ongoing process of following how the business is performing over time. This includes following a company’s quarterly earnings and other news and events that come up in between those announcements. Individuals may be able to do this for a small number of different stocks. But once that number reaches a dozen or more, it becomes a full time job. Research analysts are often specialized in specific sectors such as technology or banking so that they can compare different companies in the same line of business.
It’s important to point out one major assumption behind fundamental analysis. As mentioned above, proper analysis requires a great deal of work. Surely, analysts would only spend all this time with the belief that whatever price a stock is trading at today, that price doesn’t reflect its ‘true’ value. In other words, their role is to find those stocks that are significantly undervalued (or overvalued) so that they can exploit the fact that the stock market has got it wrong. There are some well-known investors that have a good track of finding such stocks. But many in the industry argue the market is simply too ‘efficient’ and that picking stocks on a consistent basis is very difficult and is not worth the effort.
Fortune Telling
In fact, sometimes all the fundamental analysis in the world won’t lead you to the right results. There are several reasons for this. It may be because the market simply doesn’t see the same conclusions that the analysis points to. This could lead to a lag until the time that the market finally sees the same growth prospects for a business. In the meantime, impatient investors may have given up on the company and thrown in the towel. Only to find that the stock eventually does perform well and that their initial view was right all along.
The other reality of stock picking is that there is an element of predicting the future. And, of course, that is never easy to do. So even if a company is performing well at a certain point in time, unforeseen events always occur. This can change the outlook for a business dramatically. Sticking with our example of the retail industry above, Sears was an iconic brand for decades. However, management did not foresee the impact of online shopping and now the former giant only has a small number of stores still operating in the United States.
Panic Selling
Individual stocks, including those that have solid track records and have performed well, often go through difficult periods. This is usually reflected in their valuation, as even well-established companies will see large declines in their share price at certain points in time. This may due to what is happening in the broader economy or because of company specific issues. Regardless, as an investor, you need to be know if you are able to handle these large swings in the share price. If this volatility keeps you up at night, and leads to ‘panic selling’, then you are probably not suited for stock picking.
The alternative to stocking picking is investing in the broader market through index funds or Exchange Traded Funds (ETFs). These funds are designed to mimic the performance of the broader market. (For example, the S&P 500.) Of course, the overall market can also experience some volatility. But, over time, the market has usually provided investors with more stability. Furthermore, the broader market also provides investors the peace of mind of knowing that even after periods of extreme volatility, it has always recovered in due course.
Singles and Doubles
There will always be investors that obtain a certain pleasure from stocking picking. This may come from the inherent belief that they can do better than the market by choosing individual stocks or because they derive a certain thrill from taking a more active role in participating in the stock market. These individuals should proceed with caution. Most investors that aren’t experts are likely better off with a core portfolio made up of a basket of index funds that aims to achieve their goals with a steady mix of singles and doubles. Because swinging for the fences with each at bat, often leads to a lot strikeouts.
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