There’s been a ton of research on the subject, and they all say the same thing: the vast majority of people don’t beat the market when picking stocks. In fact, active investing is notably worse than the market for many people–especially when fees are factored in. Even so, I still pick most of my stocks myself. At this point, I doubt that I’ll ever have 100% of my portfolio in passive investments.
But why? Am I just a glutton for punishment?
Well, maybe a little bit, but that’s not related to investments ;). Here are a few reasons to choose active investing.
1) Tails drive results
If you’re not familiar with a normal distribution graph, let me give you the rundown. The below is an example. You may know this as the Bell Curve.
The horizontal axis shows you how many standard deviations you are from the median, which is shown here as μ. The vertical axis tells you how often each of those points shows up in the sample. The higher the line, the more frequently it is seen. The low points on each end are called the tails.
In a normal distribution, the majority of subjects will be at or close to the average–68.26% will be within one standard deviation of the median and 95.44% will be within two standard deviations.
For our purposes, let’s say that the median equals the yearly return of the S&P 500. These days that’s around 10%.
The majority of the people in the stock market will be right around this number, but there are some people that exceed this.
It’s important to note that the tails extend out to infinity without ever reaching zero. The investors with higher than average returns will show up in the right tail. Those that have much much higher returns than the average will be even further to the right.
While our index fund investors will always show up in the median, active investors give themselves a chance to be on the right tail. And due to the great effects of compounding, increasing your return by only 1% can have enormous effects on your portfolio gains. If you put 100% of my money in index funds, you can be 100% certain that you will never exceed average returns.
You may not beat the market all the time, but by actively investing, you give yourself a chance to get lucky. As entrepreneur Bo Peabody once said, “The best way to ensure that lucky things happen is to make sure a lot of things happen.”
Morgan Housel in his book, The Psychology of Money, has an entire chapter devoted to this idea of tails–and honestly, he explains it much better than I can. Check it out if you haven’t read it yet.
2) There are always deals somewhere
When you’re invested in market indexes, you’re essentially putting your money into one asset. Granted, due to the number of companies included with this asset, the risk is pretty low. But the price still moves up and down as if you owned only one stock.
And any stock investor can tell you that certain stocks can become over/under valued at any time. Since market indexes are priced like individual stocks, market indexes can be overpriced just like stocks.
That’s where stock picking has an advantage. When you put your money in an index fund, you don’t get to control the asset allocation. In market cap weighted indexes, the most overvalued stocks have more effect on your returns than the undervalued stocks.
Trying to time the market can be dangerous, but timing the purchase and sale of individual stocks is the smartest way to play. The obvious investing advice is buy low, sell high. Any one stock can increase or decrease at any moment for hundreds of reasons, but this isn’t necessarily a bad thing. To the investor with a long-term positive outlook on that company, a drop in price becomes the perfect buying opportunity.
There is always a certain stock or industry that is undervalued at any moment. You can only invest in these undervalued assets when you pick stocks.
3) It has psychological and moral benefits
Index investing is certainly the safe way to go, but active investing is the fun way. When you pick stocks, you can join the conversation on the next up-and-coming stock and participate in the fun and excitement of watching your decision pay off.
Of course, this also comes with the risk of losing money, but that only adds to the fun. A casino is only fun because you have the chance to lose. The stock market is like a casino except the odds of success are strongly in your favor.
With enough time, stocks as a whole go up and never stop.
Picking stocks also allows you to align your money with your values. Index investing doesn’t provide this luxury. Stocks relating to oil, junk food, big pharma, chemical creation, deforestation, weaponry, gambling, and alcohol can all be found within the S&P 500 index. If you have a serious ethical issue with any one of these, you may want to reconsider where you put your money.
Conclusion
I actively invest over half of my total stock portfolio and have been doing so for the last few years. My returns are nothing the write home about, but I learn more and more about investing with each passing year. The most important thing I’ve learned is this:
Invest in what you know.
If you’re going to actively invest, be prepared to read and do a lot of research. The majority of your portfolio (95%+) should be reserved for companies that you know well and have done research on. If you’re not willing to put in the work, active investing is not for you. If you are (and if you enjoy the work like me), consider moving into the active investing realm.
Thanks for reading!
Featured photo source: M. B. M. on Unsplash
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I don’t disagree that active stock picking has the potential to out perform indexing. But it also has the potential to run out on that left curve and under perform. I am curious as to what makes you any different that any of the thousands of active fund managers, smart people with amazing tools who struggle to match the S&P 500 or total stock market indices? Aren’t they also trying to pick better than average stocks that are not overpriced? I’m not convinced one way or the other and have some of my investments managed by a company that picks individual stocks (Personal Capital) and some managed by companies that use only index stocks (Vanguard and Betterment). I am hedging my bets that way. I only have one individual stock that is really my pick, and that was my “pay” for being on a bank board, I just keep it around for sentimental reasons, its not a very large holding. I kind of think you are on the right side of the debate and your sweat equity of research and study will pay benefits. Unlike typical active managers you do not have to keep up with any particular index for fear of having your stock holders sell out. You can take a longer view since you only have to satisfy yourself, and that may well outperform over time.
There are a few differences between me and the active fund managers. 1) You mentioned this one, I don’t have to report to anyone. Quarterly results don’t matter to me, only the long-term results. 2) I don’t charge myself fees. Many active investors beat the market, but that doesn’t flow down to the clients after fees are included. And 3) I’m not working with as much money. It’s easier for me to move in and of positions.
I have no illusion that I’m some expert investor, but my active returns thus far have kept pace with the market. I’ve only been doing this a few years, but I believe that my investing skills will improve the longer I do it. Maybe I’ll never get to the point where I’m consistently beating the market, but I want to give it a shot. I have fun doing it, and I want to put myself in a position to beat the market if I can.
These are great points, and I would agree that someone with your financial aptitude and approach can feel comfortable actively managing your own portfolio. I think the argument against active management is, as you’ve said, most people are either paying for it to be done by someone else, or lack the knowledge base to do it themselves. I probably fall into the latter camp haha.
I’ll continue to preach indexing, but there’s no doubt a few individual stock picks in a downturn (such as last March) can have a huge payoff. In hindsight (which is always 20/20), it wouldn’t have been too difficult to outperform the index had I thrown spare cash at a few individual names instead of strictly into VTSAX. Ultimately I’m satisfied with the 40% growth since then, which is obviously great, even if I missed out by not concentrating some funds into stocks that have seen gains of 100%+ in less than a year.
You’re absolutely right. If you aren’t willing to dedicate the time to researching companies, active investing probably isn’t for you. There’s nothing wrong with that either. You can get great returns in index funds to set yourself up for a wealthy life.
But I do believe that anyone can learn how to actively invest. I learned the majority of my practical investing knowledge after college. Even the useful things that I did learn in college can be learned elsewhere for less time and money. My goal is to make this website one of those cheap learning places.