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It’s not difficult to understand why so many people are drawn to the idea of investing in individual stocks in hopes of “beating the market.” Picking stocks plays into several cognitive biases that humans suffer from, including overconfidence. Overconfidence is when people overestimate the probability of a good outcome and underestimate the probability of a bad outcome.
As I will demonstrate with data, anyone who picks stocks has an overconfidence bias. To be more specific, unless your name is Jim Simons or Warren Buffett, it is your portfolio that suffers from a stock picking habit.
If you’ve made it to the ninth chapter in a book about investing in index funds, you may be wondering, why would anyone bet their financial future on their ability to pick and choose individual stocks?
The same reason people go to the Casino; it’s fun, and they want to get rich quickly. In defense of anyone who picks stocks, the entire financial media ecosystem has been constructed to promote stock picking as a viable investment strategy for ordinary people.
If every blogger, investment newsletter, and TV show dedicated to the stock market told you the truth—your best bet is to buy a few index funds and sit on them for 20 plus years— they would quickly run out of business.
It’s much easier to fill a 24/7 financial news cycle with stories about individual companies and whether you should buy, hold, or sell each of them than continue reporting that “yes, you should continue buying and holding index funds today.”
Those who promote picking stocks are pushing a compelling story. That story is usually some variation of “If you listen to me, you too can become rich picking stocks.” However, if you look at the data and academic research, it’s clear that the story that stock pickers are pushing is simply that; a story.
The reality of picking stocks
Investing in the stock market is inherently riskier than investing in a safe asset such as short-term government bonds. Investors accept this increased risk because they are compensated with a higher expected return. The difference between the expected return of the stock market and risk-free assets is referred to as the risk premium for stocks.
If the stock market did not have a risk premium, there would be no incentive to invest in the stock market. Why take on more risk if you are not expecting higher returns? It’s important to understand the two types of risk investors take on.
The risk that the entire stock market could drop is a systemic risk. Investors cannot diversify that risk away, but they are compensated with a risk premium.
The risk that an individual company or industry could collapse is called idiosyncratic risk. Investing in individual stocks presents an additional risk that investors aren’t compensated for.
Translation; picking stocks introduces additional risk without increasing your expected return. There is no rational basis for investing this way.
Much like the stock pickers, I just spun you a simple story about investing. Unlike the stock pickers, I will back up this story with academic research and data.
The Efficient Market Theory
We briefly touched on the efficient market theory in chapter 3. If we accept that the stock market is efficient, it’s reasonable to conclude that the most rational investment decision would be to invest in the entire stock market through low-cost index funds.
In a 1965 paper, the University of Chicago Economics Professor Eugene Fama concluded that stock market prices move randomly and that the price of stocks is representative of all known information.
Put simply, Eugene Fama’s research suggests that the stock market is reasonably efficient. In 2013, Fama won the Nobel Prize in Economics due to his research in this area.
Fama’s research would suggest that it’s impossible for stock pickers to consistently beat the market. Stock pickers that do beat the market likely have done so due to luck rather than their brilliance and intuition.
The problem is that humans have a destructive habit of mistaking luck for skill. The more success you have, the more likely you are to believe that success is due to skill.
Numerous investment gurus called the financial crisis of 2008-2009 before it happened. This brought them fame and fortune and a standing invitation to appear on more financial TV shows. But when you take a closer look, you discover that these gurus are predicting a stock market crash every 18-months, and nine times out of ten, they are dead wrong.
This is a perfect opportunity to remind everyone of a simple truth about decision-making; a bad decision (like picking stocks) can lead to a good outcome. That does not mean it was a good decision.
Let us now move to the data and evidence that suggests that picking stocks is, in fact, a bad decision.