Team Favorite At the Money: Should You Be A Stock Picker?

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0:58I'm Barry Ritholtz, and on today's edition of At The Money, we're going to discuss whether or not you should try your hand at stock picking. It's fun. It gives you stuff to talk about at parties. But is it profitable? To help us unpack all of this and what it means for your portfolio, let's bring in Larry Suedro, head of financial and economic research at Buckingham Strategic Wealth. The firm manages or advises on over$70 billion in client assets. And Suedro has written or co-written 20 books on investing. So, Larry, I know you're not a big fan of stock picking. What's the problem with throwing a couple of great stocks into your portfolio?

1:41If it's done for an entertainment account in the same way that we don't expect to get rich going to Las Vegas, no one would invest their IRA in the casinos of Las Vegas or go to the racetrack with it. So that's OK if you're prepared to lose. The evidence is very clear that stock pickers on average lose because of their trading costs, not because they're generally dumb. Although I will add this, Barry, the typical retail investor is actually dumb or naive and they get exploited by institutional investors. And it's a lot to do with biases on the behavioral side. They like to buy what are called lottery-like stocks, things that the vast majority of the time do poorly, but occasionally you find the next Google.

2:40So stocks they like to buy include things like stocks in bankruptcy, penny stocks, small-cap growth stocks with high investment and low profitability. Those stocks have underperformed treasury bills, but they're the favorites of the retail investors, and the institutions avoid them, giving them somewhat of an advantage. I know you wrote a book about what a great investor Warren Buffett is and how we can invest like him. Peter Lynch was a great stock picker. Carl Icahn, Bill Ackman, all these different Fidelity fund managers have been great stock pickers. How hard can it be? Why can't we just go out and pick a few great stocks and that's our portfolio?

3:22Right. OK, so let's start with the premise that markets are not perfectly efficient. There are a few people who have managed to outperform for whatever reason. And I would agree with you that Peter Lynch certainly was a great stock picker. Maybe Bill Ackman, you could add. I would disagree with Warren Buffett being a great stock picker, taking nothing away from what Buffett did. But the research shows that Buffett generated massive out returns, not because of individual stock picking skills, but because he identified certain traits or characteristics of stocks that if you just bought an index of those stocks, you would have done virtually as well as Buffett did in the stock picking.

4:12He has been telling people for decades to buy companies that are cheap, profitable, high quality, low volatility of earnings, etc. And the academics, through reverse engineering, though it took him 50 years to figure it out, now have identified these characteristics. and all of the mutual funds I use run by companies like Dimensional, Bridgeway, AQR, they all use the same strategies. And Buffett's Berkshire has not outperformed in the last couple of decades because the market has caught up to him and eliminated those anomalies, if you will. You can do the same thing. So it takes nothing away from Buffett.

4:58He gets all the credit for figuring it out 50 years before everybody else. But it wasn't stock picking, and it certainly wasn't market timing. So I know the indexes will give me 8%, 10 % a year annually, and those are great returns. But Netflix is up like 1 ,000 % over the past couple of years, and NVIDIA is up 3 ,000 % over the past couple of years. Wouldn't that goose my returns if I can own companies like that? Yeah, that's certainly true, Barry, but we got a couple of problems with that. But by the way, those kind of returns are the ones that encourage people to try to hit those home runs.

5:40The data shows this out of the thousands of stocks that are out there over the now of 100 years virtually of data in the U.S., only 4 % of stocks, 4 % have provided 100 % of the risk premium over T-bills. What are the odds you're going to be able to find those stocks? Problem number two is people cite the NVIDIAs, but they also forget that last year, a good example, while the S &P was up 26.5%, 10 stocks underperformed by at least like 60%, at least 60%. They're down at least 32%. So everyone likes to point out the winners, but you also then have a good shot at getting the losers. In fact, the odds are you're going to pick the losers.

6:34Here's why. Because only 4 % of all the stocks account for all the outperformance, that means the average stocks underperforms the average. So the odds are you're going to pick the underperformers, not the outperformers. That's simple math. So the more stocks you own, the better your odds of earning the average. So if I'm a stock picker and I have a full-time job and I'm doing this on the side, what sort of performance should I expect? You should expect a performance that if you are familiar with asset class pricing models. So if you buy a large value stock, you're probably going to get the returns of a large value index.

7:21but with a lot more volatility because you own one stock instead of maybe 200. So you could have what's called tracking variance around that of 5 % or even 10%. But the more stocks you own, the closer you're going to get to that index. So why bother? You're better off just owning the index at very low cost. You don't have to spend any time doing it. Your life will probably be a lot better because you'll spend more time with your wife and your kids enjoying a nice round of golf or a walk in the park or do what I do playing with my grandkids. You get a lot more pleasure out of that than trying to pick stocks that time the market.

8:02What about emotional biases? How do they affect people who think they could go out and pick the winning stocks versus simply owning a broad index? Yeah, there's certainly that emotional biases are part of the reason people think they're going to outperform. The research shows, for example, that we're human beings and we tend to be over-optimistic, over-confident in our skills, so that 90 percent of the people think they're better than average, regardless of the endeavor, whether it's whether you're a better than average driver, a better than average lover, or a better than average stock picker.

8:43So you think you're likely to outperform. In fact, studies have shown people were asked, did you outperform? And by how much the people who thought they actually outperformed actually even lost money in the years. Not only did they not outperform. So his selective memory creates a problem as well. Amazing. One of the things I've heard people talk about is setting up a small, what I've heard described as cowboy account, where they can throw caution to the wind. They take less than 5 % of their liquid assets, and that's as much as they're willing to risk, and allows them to scratch that itch of either stock picking or whatever it is.

9:27What are your thoughts on that sort of approach? Taking 5 % of a portfolio is not likely to cause you great harm. And if you don't do a lot of trading and you build a little bit of diversified, you're probably going to get something like market returns. And if you follow the research as presented in my books, you can avoid those lottery stocks improving your odds. You know, but my question to you is if you need to get enjoyment out of stock picking to have a good life, I suggest you might want to get another life. Now, I say that with tongue in cheek because people like to go to the racetrack and, you know, go to the casinos.

10:09There's nothing wrong with that. But if that's what you really need to enjoy your life, you might want to think about where your values are. Again, I say that with tongue in cheek. So to wrap up, investors who think they can become winning stock pickers face long odds. Most of the stocks that are out there will underperform the index and certainly not be a source of outperformance. The odds are that they're going to add risk and volatility while spending a lot of time and effort to pick stocks. And the key takeaway is they're going to underperform a broad index anyway. That's what they need to understand.

10:47And if you want to set up a cowboy account with a tiny percentage and play with it, knock yourself out, have some fun. Just recognize that's all it is, and your real money should be locked away and working over the long haul for you. I'm Barry Ritholtz, and this is Bloomberg's At The Money. Because I'm a picker, I'm a grinner, I'm a lover, and I'm a sinner. I play my music in the sun. Thank you.