Pitfalls of stock picking

“If something can’t go on forever, it will stop.” I wish I could take credit for that line, but I can’t. It’s attributable to Herbert Stein, who was the Chairman of the Council of Economic Advisors in both the Nixon and Ford administrations. This pithy aphorism informs a lot of my thinking with respect to stock selection. A second notion that also has considerable weight with me is the idea that when a stock price changes — or the price of virtually anything, for that matter — it’s very difficult to know whether that change reflects the start or continuation of a trend, or whether that change is going to be a temporary aberration soon to be reversed. People guess about which one of these alternatives applies and invest accordingly. When they’re right they win; when they’re wrong, they lose.

Putting these foundational ideas aside for the moment, stock market investors often divide between those who look for stocks that have been appreciating — essentially betting that the recent trend will continue — versus those who look to find the unfound gems that are undervalued and thus represent particularly good prospects for appreciation in the future. In fact, common parlance labels the first category of investors as those who would seek to buy growth stocks and the second category as those who would favor value stocks. Secondarily, the history of appreciation informs our sensibilities about expectations for future price appreciation. Generally, I think it’s safe to say that the expected appreciation for growth stocks is likely to be higher than that for value stocks, albeit with greater volatility (i.e., risk). It’s a subjective judgment as to where an investor should position him or herself on this risk/return spectrum.

With the growth versus value distinction in mind, it should be understood that at the initial point of designation, a growth stock would have generally outperformed a value stock in terms of total return over some relatively recent history, but Herbert Stein’s quote warns us that this outperformance can’t go on forever. At least theoretically, appreciation for the growth stock could reverse and the price of the value stock could advance to the point that both stocks could fall out of their originally designated categories.

It’s fairly typical for naïve or unsophisticated investors to be seduced into entering into an investment because of a history of extraordinary price appreciation — more likely to happen in the case of a growth stock. Here, the motivation underlying the investment is often the fear of missing out (FOMO), as opposed to any rigorous assessment of risk and reward; and all too often, the consequences are sobering. In any case, this phenomenon of FOMO investing certainly contributes to the price volatility that we see associated with highly-visibility investments — i.e., stocks that receive considerable attention in response to extraordinary (and, again, unsustainable) market advances. Psychologically, people who’ve entered the market prior to any significant price increases may not feel so bad about returning even substantial portions of their unrealized gains; but this comfort level in the face of a market decline wouldn’t be shared by those who entered their positions at more elevated prices.

The sweet spot in picking stocks, of course, is identifying a stock that shows attractive earnings growth (and seemingly solid growth potential), but where the stock appears to be undervalued relative to those earnings projections. More power to you if you can make this assessment correctly and consistently, but it’s no easy task, as reflected by professional investors who, historically, have shown little success in consistently outperforming the total return of S&P 500 index over time — i.e., the well-accepted benchmark of stock market performance.

Last year happened to be a particularly good year for active fund managers. Even so, in the first half of the year, with just under half of large-cap managers managed to beat the index. This performance, however, turns out to have been highly unusual. S&P Dow Jones Indices reports that only about 10 percent of actively managed funds outperformed this benchmark index.

Arguably, this history of pervasive poor performance on the part of professional managers is the most substantive justification to rely most heavily on investment products that mimic the S&P500 index (i.e., mutual funds and exchange traded funds) for the lion’s share of any investment portfolio, relegating individual stock selection to only a small portion of your portfolio’s composition — if any.