Aurum Wealth Management Blog

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Picking a Stock: Not For The Faint of Heart

Jesse Livermore, considered by some the most famous trader ever, learned to trade in the bucket shops in the early 1900s. He profited from the 1929 market crash by betting it would fall, and certainly earned his nickname, “Boy Plunger.” In today’s dollars he would have been a billionaire. The wealthy Mr. Patridge was a keen influence on Jesse Livermore, especially in his early days.  Mr. Patridge never traded off stock tips and anyone who would ask him for one would get a simple response, “Well it’s a bull market, you know.” It was his way of saying that the trend in stocks was up (without giving away an actual tip). Telling another person a stock to buy never was his thing, because how would the person acting on another’s information know when to cash out?

“What’s your favorite stock today?”

“Give me a name.”

“What are you buying?”

Everyone in the financial advice business has been asked this question.  Sad to say, most were probably disappointed with my response.

Typically, I explain that picking single stocks is just not what we do. If you want to talk about grilling a portfolio manager to separate the wheat from the chaff, we are all over that.  Talking about asset classes that are rich or cheap – yes, please! Both matter far more to portfolio outcomes anyways.

We have stock ideas, of course. Talking to sharp portfolio managers on a regular basis will bring this. While learning about emerging industries and trends, more possibilities unfold. But narrowing it to a single recommendation, the possible outcomes are just… far too random.

When it comes down to it, picking a stock is quite an arrogant activity.

In choosing a stock, the selector is saying he or she knows more than the collective wisdom of “Mr. Market.” Domain expertise could give one an edge to make the activity a positive tilt. Still, many things can go wrong for a single stock. A product could be upended by technological innovation.  Management could be bad actors. A value stock could stay cheap for a good reason and never recover… the list goes on.

Professor Hendrik Bessembinder of Arizona State University recently published a paper in August 2017 titled, “Do Stocks Outperform Treasury Bills?” In it, he studied the database of returns from 1926 to 2016 from the Center for Research in Security Prices for all public stocks that ever existed. This included about 25,300 stocks, which over time created $35 trillion in shareholder wealth.   He found that 1,092 of these stocks accounted for all wealth creation, or only about 4% of stocks. Just 90 companies, or one third of one percent, accounted for half of the wealth creation!

In addition, he found that 58% of stocks did not beat 1-month Treasury bills (i.e., cash) if held forever.  The most common outcome for holding a stock forever is a complete loss, -100%.

In more recent decades, the same study produces similar results. The chart below shows that two thirds of individual companies underperformed the Russell 3000 index and 40% produced negative returns. The extreme winners are what drives the market index higher, which comprise just 7% of the market (think Amazon, Berkshire Hathaway).

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The bottom line is that diversification plays an important role in financial planning and portfolio management. Missing out on the big winners would diminish the average returns for a portfolio. While picking stocks for a small portion of assets could be interesting or even entertaining, it stacks the odds against outperforming a simple market index.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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