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Strategy Lab

Don't write an obituary for stock-picking just yet Add to ...

Chris Umiastowski is the growth investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

Last week, in announcing his retirement, a Morgan Stanley global investment strategist told his clients that stock picking is essentially a waste of time.

This is not what you expect a professional investor to say. But Gerald Minack pointed out that low-cost index funds typically beat the majority of professionally managed money. He wrote that investing is perhaps the only profession where “amateurs have a good shot at beating the pros.”

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I very much enjoyed the detailed comments on Mr. Minack’s note by Henry Blodget.

Mr. Blodget, as you may recall, is a former Wall Street analyst who covered the Internet sector for Merrill Lynch during the dot-com era. He was accused of fraud by former New York State attorney-general Eliot Spitzer, and subsequently agreed to a fine and a permanent ban from the securities industry.

Today, he is the CEO of The Business Insider. He’s also an advocate of index investing. So when he wrote about Mr. Minack’s parting advice to clients, I was intrigued by the spectacle of two former pros, who know the system as well as anyone, speaking out against the idea of picking stocks.

The evidence they point to is rather overwhelming. For example, Mr. Minack shows that over the three years to 2012 a staggering 87 per cent of actively managed mutual funds underperformed their benchmark index.

This raises an obvious question: Why should anyone take a chance on investing in an actively managed mutual fund given the huge probability that it will lose out to a low-cost index fund?

For that matter, why are three of the Strategy Lab participants (myself, value investor Norm Rothery and dividend investor John Heinzl) picking stocks? Shouldn’t the evidence put forward by Mr. Minack and our own colleague Andrew Hallam cause us to hang up our hats and switch to index investing?

I’m not entirely convinced. Let me explain why.

As Mr. Blodget points out, what really kills returns for the mutual fund investor are the fees you pay. Management expenses drag down your returns, typically by one to two percentage points a year in Canada.

But fees on a self-created stock portfolio are extremely low. Let’s say you build your own “fund” by investing $5,000 per stock. With $10 trading fees, your cost is a mere 0.2 per cent to set things up and zero per cent to maintain your portfolio. Not even an index fund can beat that.

But doesn’t Mr. Blodget also say that stock picking is idiotic? Yes, and if we look at how most people pick stocks he is absolutely right. Most people chase short-term performance. Amateurs and pros alike believe they’re smarter than everyone else, and have a sixth sense permitting them to time their buys and sells.

That’s not how I or the other Strategy Lab investors behave. We think more like index creators. We select stocks based on a philosophy or a set of criteria. For the most part we intend to hold the stocks we pick for a very long time.

In my case, I look for companies that are leading in important, emerging industries. I hope to hold them for decades. I think of my Strategy Lab portfolio as a mini-index of promising technology-oriented companies that has even lower costs than an ETF or mutual fund. (On a personal note, I buy ETFs too for my real world portfolio. I don’t put all my money in the tech sector.)

There are only two ways that stock picking can make you wealthy. One is to get very lucky. The other, more realistic, strategy is to pick quality stocks and stick to them for the long term. That requires discipline, which is one reason that stock picking is not for everyone.

Like Mr. Minack and Mr. Blodget, I believe most people should not pick stocks. It requires an investment in time. It also requires knowledge. The vast majority of the population doesn’t know enough about stocks to be investing in them individually.

For all those reasons, indexing is the smart strategy for most people. But if you’re one of the minority of the population who are willing to devote the time and energy, I think there’s still good reason to research and select your own stocks – so long as you keep three principles in mind.

First, think of your portfolio as your own index and make sure it’s constructed on explicit, well-defined principles. Second, stick to a long term strategy and don’t try to time the market. Finally, don’t be afraid to balance your own stock selections with low-cost ETFs that index parts of the market you don’t have the time to follow.

Do all of this and I think you have a chance to do even better than those smart index investors.

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