Jul 272020
 

Stock picking vs index investing

There’s a common belief that attempting to outperform the stock market is futile. A thread on the r/investing subreddit asked if anyone can beat the market. Here are some direct replies from the community:

  • “I know I am statistically extremely unlikely to beat the market, and if I do beat it, it’s through luck, not skill.”
  • “The only way you can really beat the market is to hold a highly concentrated portfolio and hit it big in 1 stock”
  • “As a retail investor, if I beat the market picking individual stocks, it was mostly from luck.”

Even an investopedia.com article suggests that successful stock pickers like Warren Buffett may have just been “exceptionally lucky.” It appears the online investing community is generally against the idea of individual stock picking. This short comment from the forums of RedFlagDeals sums it up well.

But allow me to go against the grain and push back a little. 😎 I believe you canΒ beat the market if you have the right decision making process. πŸ™‚ My net worth today is largely built on my stock picking history.

Internet consensus: Amateur investors can’t beat the market over time. That’s why you should just buy index funds and forget about stock picking.

Me:Β 

beating the index

12.87% is the annual rate of return on my TFSA portfolio over the last 9.5 years according to TD portfolio statistics. It’s one of my oldest investment accounts. As readers will know I share all my stock holdings publicly for accountability reasons.

It appears the couch potato method of index investing is very popular with netizens. In the subreddit, r/PersonalFinanceCanada even the moderators have admitted that, “the general consensus on PFC is that people should look for low-cost, passive index investments.”

Don’t get me wrong. The Canadian couch potato aggressive portfolio performed quite well over the last 10 years. I’m just saying maybe there are better investment strategies out there. πŸ™‚

Source: https://edrempel.com/outperform/

 

Why index investing isn’t all that passive

Index funds may appear to be passive, but they are actually more actively managed than most realize. This is something the index investing community doesn’t like to admit because it undermines the strategy’s reputation of being objective, hands off, and untainted by human biases.

The truth is most indexes contain selective stocks based on subjective factors. For example, components in the popular S&P 500 index are chosen by a committee at investment company S&P Dow Jones Indices. It’s basically a handful of people getting paid to actively manage a list of stocks that they believe should represent the overall equity market. But you have to wonder – if they are so good at analyzing securities why aren’t they working for a hedge fund?

David Blitzer currently heads the S&P 500 committee. David and his pals set the rules and criteria for the S&P 500 and other indexes. Those guidelines could be based on liquidity, earnings, and other subjective metrics that could change over time. As such, the committee adds and removes components of the index on a fairly regular basis. For example, about 1 in 3 of the index components changed between 2000 and 2005. Can you imagine if one third of your holdings changed every 5 years? As a buy-and-hold investor I do not agree with this practice.

 

Index managers should get out of their own way

Advanced Micro Devices (AMD), a stock I own, was kicked out of the S&P 500 index in 2013 for failing to meet an arbitrary market cap requirement. But was then re-added back into the index 4 years later in 2017. So what happened over those 4 years? AMD’s price soared from $3.86/share to $13.49/share. Index investors in the S&P 500 lost out on that juicy 250% stock appreciation. A lesson often taught to beginner investors is that time in the market beats timing the market. It’s not clear if David Blitzer got the memo. Maybe he should read my blog. πŸ˜‹

According to professor of finance Jeremy Siegel, more than 900 new firms added to the index since its inception in 1957 had, on average, underperformed the original 500 firms in the index!

In other words, investors would have been better off had they simply bought the original S&P 500 firms and never made any changes to their portfolio. The committee’s efforts of switching in and out different stocks were very counterproductive. Go figure.

There were over 1,000 component changes to the S&P 500 in just the last 50 years. That’s a lot of trading activity.

Mebane Faber, CIO of Cambria Investment Management points out, “it’s ironic that the largest and most famous index, the S&P 500, is really an active fund in drag. It has momentum rules, fundamental rules, and a subjective overlay (committee input).”

 

Other indexes to consider

The Dow Jones (DJIA), another widely followed market index, covers 30 large-cap companies, which are also subjectively picked – this time by the editors of The Wall Street Journal.

In Canada, the S&P/TSX index components are reviewed quarterly and all Index Securities that, in the opinion of the Index Committee, do not meet certain requirements are removed.

Perhaps the only real passive indexes are ones that cover the total market. The CRSP U.S. Total Market Index for example has nearly 4,000 constituents across mega, large, small and micro capitalizations, representing nearly 100% of the U.S. investable equity market. (VUN) is an ETF you can buy in $CAD to get exposure to the entire U.S. market. The $USD equivalent fund is the Vanguard Total Stock Market ETF (VTI).

Better yet, why not buy a stock index that covers the entire world? πŸ˜€ Here are a few options to consider:

  • $CAD – iShares Core MSCI All Country World ex Canada Index (XAW)
  • $CAD – FTSE Global All Cap ex Canada Index (VXC)
  • $USD – Vanguard Total World Stock (VT)

According to financial planner Ed Rempel, a total market index of global equities has produced the best gains in the past. Ed was a guest in an episode of the Explore FI Canada podcast earlier this year. During that conversation Ed shared his findings that tracked 4 popular investment strategies over a 10 year period.

The result? The best performer was the total return strategy – which is basically the MSCI world index. The Couch Potato (aggressive) portfolio came in last place. I recommend giving the full episode a listen, especially if you’re an index investor.

couch potato, total world index, and dividend return comparison

Image source: https://exploreficanada.ca/podcast/029-outperform-advisors-ed-rempel/

 

A case for picking individual stocks

Here are some reasons why individual stock picking can be more rewarding than index investing.

  1. There are no annual management fees if you hold your own stocks.
  2. Instead of holding good and bad stocks, you can choose to buy only the best quality and best performing companies – increasing your chances to outperform the broad market over time. You can tell which companies are likely to outperform based on their track record of earnings growth relative to their peers. Look for industry leaders such as JNJ, RY, PEP, GOOG, etc.
  3. Index funds have a lot of churn as mentioned earlier with the S&P 500 index. The more you buy/sell the less money you will make. Investors can buy their own basket of stocks and leave it alone. Over time this will statistically earn a higher rate of return than investors who hold index funds which track the trading decisions of a committee.
  4. You may have superior information based on your expertise in a specific field. There’s no crime in investing in what you know. For example, I have only participated in one IPO ever. That was Match Group (MTCH.) I’ve used many of their products and knew the company was going to be big. I understood the company’s products more than Wall St. analysts because I’ve personally used the services and can see their potential. πŸ’˜So I bought 100 shares on its first trading day in 2015. Today $MTCH shares are valued at over 5 times higher. πŸ˜€ You can’t get this type of return by only investing in index funds.

 

Other stock pickers

Other bloggers are beating the market too, such as Bob from Tawcan.com. He outperformed the S&P/TSX composite with his personally curated portfolio of mostly dividend stocks over the last 8 years. Bob and I both work full time and are not professional traders. Roadmap2Retire is holding a stock picking contest in 2020 among PF bloggers. So far it appears about half the bloggers are beating the S&P 500 index, which is to be expected. Mathematically speaking if you randomly choose a basket of stocks to buy and hold you will have a 50% chance to beat the market over time. It’s unfortunate that so many investors are convinced to believe they suck at choosing individual investments before they even try.

Don’t let anyone tell you that you can’t be a successful stock picker if you haven’t tried it yet for yourself. Investors who buy an index fund essentially buy a list of companies chosen by other people. But investors who choose their own stocks effectively build their own index fund using more personalized criteria. This makes it easier to align with one’s unique investment philosophy.

Picking stocks is more time consuming than simply indexing. But it can pay off very well if you make the right moves. πŸ™‚ Although some people can beat the market over time, it’s not a viable strategy for everyone. By definition half of investors will underperform the average, and the other half will do better.

 

How to tell which investment style is right for you

Passive investing is like following a popular diet or meal plan program. You don’t have to think for yourself. You just do what the diet tells you. This may be the appropriate choice for some people. But others may want to discover more unique, personalized diets that work better for themselves. This is similar to building your own investment portfolio. It requires research. But can often lead to better personal results. Both strategies are valid. So which path should you pursue? Here’s one way to tell.

Create 2 portfolios: one for index investing, and the other for stock picking. Track the performance of each one month after month and see if they diverge. After a year the portfolio with the higher return is likely more suitable for your investment style. Outperforming the index might be easier than you think. Or it might be harder. But if you don’t try, then you will never know for sure if you can beat the market or not.

Continue to track both portfolios for many more years. The longer you track them the more confident you will be about which method is right for you. πŸ˜‰

I personally have a hybrid portfolio of mostly individual stocks along with some ETFs. If you currently like your stock portfolio and have the time to monitor them, then I think you should keep your stocks. You could always sell your individual stocks later if you change your mind. The main thing is to find a style that best suits your personal circumstances. πŸ™‚

 

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Random Useless Fact:

sponge bob paying

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Potato Head
Potato Head
07/27/2020 8:51 am

The couch potato portfolio does not use the S&P 500, it uses the US Total Market instead, so you’d not be missing out on AMD or any other major winner (e.g. Tesla).

The idea behind such portfolio is not to maximize returns, but to reduce volatility. In extreme market downturns, if you have a 1M portfolio on a handful of stocks and they drop 50-80%, it will be hard to stomach it and not sell. With a 60/40 portfolio, you’ll be looking at a 20-40% loss, easier to stomach.

If you are looking at a long timeframe and have discipline to not sell when things turn ugly, then you can outperform index investing. In my case I know I’m not disciplined enough, and wouldn’t be able to stomach a large loss, even if temporary πŸ™‚

Chrissy @ Eat Sleep Breathe FI
07/28/2020 10:47 am

Hey Liquid,

Thanks for the shout-out! We really enjoyed that episode with Ed. As much as I already understood the value of investing globally, I didn’t fully grasp it until that interview.

Additionally, I’ve been on the indexing bandwagon for years, but (shhhh) have recently become more educated about active investing. You’re right that, with skill and knowledge (not just luck) it is possible to do better than the indexes.

I appreciate reading your intelligent, well-written thoughts on the topic. (As well as the hilarious memes you created for this postβ€”LOL!) Thanks for sharing your knowledge and experience.

Rachel
07/30/2020 6:44 pm

Great post liquid! As an indexer I listened to Ed on the podcast – great episode. Currently my index portfolio is all in VEQT for simplicity at small size with a long horizon at 23. It’s clear now the 30% home bias will play a role in how the returns differ from the world index (be it good or bad). My dad biased me against bonds similarly to Ed’s view so it was nice to hear 3rd party validation πŸ˜‚ I would consider switching if there was a simple enough/cost comparable MSCI world index alternative but I have yet to find one…. and VEQT’s available past performance is better than XAW’s by about .3%. It’s too bad no one has come out with a comparable ETF to VT in CAD. (Other than XWD which is pricey..) The regular conversions to USD with regular contributions I feel would probably be pretty expensive if done via Questrade and a risky headache trying to Norberts Gambit as a newbie in a volatile market. Anyways, rambling. My question out of all this, would you consider trying Norberts gambit to buy and hold VT in an RRSP – or in your experience is it too… Read more Β»

Rachel
08/01/2020 12:27 pm

My dad does take pride in being a contrarian himself… he would probably enjoy your blog πŸ™‚

Appreciate the reply Liquid! I was thinking the same at the end of my rabbit hole on this … as they say, perfect is the enemy of good. πŸ˜‰

Investingretire
07/31/2020 10:05 pm

Great post and spot on! It really depends how comfortable you are in picking stocks. Other than Index investing, there are also now ‘active’ ETFs, these are sort of mutual funds under an ETF structure. Not exactly as cheap as regular index ETFs, but can be a good alternative given the manager is good

Brian
Brian
08/01/2020 8:41 am

Where would be the best place to hold XAW? in my RRSP or TFSA? does XAW have a us or international withholding tax?

Rachel @ Reality Cheque Blog
08/01/2020 12:31 pm
Reply to  Brian

PS – Check out Justin Bender’s foreign withholding tax calculator, he has a fantastic breakdown of common ETFs and the consequent impact of foreign withholding tax on their cost depending which account they are held in. Super useful for factoring in the “true cost” of holding and selling an ETF.

https://www.canadianportfoliomanagerblog.com/calculators/

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[…] As an opponent of the Efficient Market Hypothesis I prefer to buy underpriced individual stocks rather than the entire market. […]

Apeirox
Apeirox
08/11/2020 12:42 am

Hi Liquid,

“Mathematically speaking, if you randomly choose a basket of stocks to buy and hold you will have a 50% chance to beat the market over time.” does not hold when the distribution of companies’ returns is skewed, which is usually the case. E.g. from 1998 to 2018, median return of a S&P500 constituent company was +50%, while average return was +228% (https://www.spglobal.com/spdji/en/documents/research/research-the-slings-and-arrows-of-passive-fortune.pdf, p.17). The returns were heavily right skewed.

To demonstrate the effect on a simple example, let’s say that we have 100 companies in and index. Over some time period, 99 out of them return +100% and one returns +9900%. If you randomly pick a bag of 10 stocks (equally weighted), you have only 10% change to hit the winner and outperform the index (+1080% vs +198%), and 90% chance that the index will beat you (+198% vs +100%).

I’m not trying to say that picking individual stocks is a bad idea… but I think that beating an index isn’t that easy, which makes your results even more remarkable.

Family Money Saver
08/11/2020 12:43 pm

Great article, love the memes too. Another problem with Indexes is there are lots of great companies or potential growth opportunities that certain funds just can’t participate in for a variety of reasons. It basically eliminates the potential of really outsized returns.