Pick Stocks! Why Self Directed Investors Should Engage In Buying and Selling Individual Stocks!

It is excellent advice for self directed individual investors to use broadly diversified index funds as the way to gain exposure to stocks (equities).  Every year, S&P Dow Jones Indices does a study comparing active stock picking to passive investing through the index.  The research shows that after 10 years, 85% of all active large cap funds trailed the S&P 500.  Over a longer time period, 15 years, 92% trail the index.  In his famous book, Winning the Loser’s Game, Charlie Ellis vividly illustrates the point.  He compares investing to beginning or intermediate tennis.  In those levels of the sport, the vast majority of players make a lot of errors.  As a result, the best way to win is by keeping the ball in play and letting the opponent beat themself.  With investing, Mr. Ellis points out a large percentage of active fund managers don’t have better returns than indexes.  As a result, the best way to invest for individual investors is to own indexes or ETFs.  Mr. Ellis is a wise man and an accomplished investor.  Still, I think there is value in the activity of picking stocks.  Let’s see why I believe there is a place for active investing (stock picking) for self directed investors.

First, we know the odds are active investing will not lead to outperforming the S&P 500.  However, the active investor gains a great deal of knowledge by researching and investing in individual companies.  As one gains experience and learns about a wide range of industries and businesses, understanding financial statements and how the markets react to financial performance becomes ingrained in the active investor.  In addition, learning how individual companies are valued by the market builds a knowledge base for the active investor.  These skills can be applied to a wide variety of asset classes, including indexes, bonds, or private investments.  One of the wonderful things about investing is it is a never ending learning process, especially when you invest in individual stocks.  

Second, a fact for all investors to consider is there are periods where investing in a broad market index for a country or the globe will lead to zero performance (the loss of money).  As an example, the Japanese Nikkei reached an astronomical value of 38, 915.87 in December of 1989.  In December of 2021, the Nikkei sat at 28, 791.71 (https://www.afrugaldoctor.com/home/japans-lost-decades-30-years-of-negative-returns-from-the-nikkei-225)   For thirty two years, if you owned the index, you were watching it’s value erode.  Clearly, the price in December of 1989 was excessive and an investor was getting very little for their money if you bought during that period.  Let’s take another example, this time, from the United States: the S&P 500.  The historical results show you the reasoning behind investing for the long term.  Under no twenty year period did the S&P 500 suffer a loss.  However, from 2000- 2010, the S&P did undergo a period where the annualized real return was negative: -3.42%

(https://www.afrugaldoctor.com/home/japans-lost-decades-30-years-of-negative-returns-from-the-nikkei-225) It is a similar situation to the Nikkei in that the S&P 500 was trading at an elevated price during 2000.  It was the internet bubble era and in hindsight, valuations were clearly stretched.  

These examples show how being an investor who invested in specific stocks might have been better able to manage through these periods.  First, by not tying your entire investment strategy to a passive index which may be dramatically overvalued, you are multidimensional in how you are investing your portfolio. Second, experience investing with individual securities will help you understand the important metrics you need to know when evaluating specific index funds or ETFs.  Yes, investing in passive indexes has a long term track record of being a better alternative than active investing.  As a self directed investor, you can do both and by having exposure to active investing, you will improve your knowledge and become a better investor. 

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