Don’t Buy Stocks, Part 2

“Individual investors tend to invest in a small number [of stocks] and they don’t know how to construct a portfolio.  Professional portfolio managers control risk.” – says Jim Peterson, vice president at the Schwab Center for Financial Research.

In the June 10th post, I wrote about the dangers of buying stocks in companies you think you know well, and I extolled the virtues of diversification.  One reader posted a comment saying that he believed that owning 30 to 35 individual stocks was “sufficient” diversification.   I’m not so sure.

Today’s Hot Tip: Don’t Buy Stocks! an article by Howard Gold, written in 2008, reinforces my arguments.  He interviewed several professionals to make his point.  Here is a summary of his article.

William Bernstein, a money manager and the author “estimates that because of close correlations between markets, even 100 carefully chosen stocks can’t match the diversification of holding just a couple of index funds and ETFs that cover the global market.”

If you’re still not convinced, just how much work are you willing to put into picking stocks?

According to Gold, “even individuals who have good stock-picking skills rarely can do the necessary research to post consistently good results over time.”

He quotes a study by the Schwab Center that “tracked the portfolios of Schwab clients who had $5,000 in household equity and whose accounts were either at least 95% individual stocks (including foreign shares and ETFs) or 95% open-end equity mutual funds.

The survey, taken over 2005-2006, produced stunning results:

The fund investors substantially outperformed the stock pickers, with less than half the risk and after all expenses.

Though it covered only two years—and the investors may have held other assets at other financial institutions—it did take in a huge number of the 3.5 million clients of Charles Schwab, about as good a sample of the US investing public as you can find.”

Doing Your Homework

“You have to have tremendous energy to devote to the stock-picking process,” says David Swensen, chief investment officer of Yale University. “Individuals don’t have the time or the resources.”

In his book “Unconventional Success: A Fundamental Approach to Personal Investment,” Swensen advises individuals to stick to a set of broadly diversified index funds.

“If you try to manage your own money and invest in your own stocks, and you don’t…do every single piece of homework necessary, you won’t beat the market, and you’ll probably lose money,” says one well-known investing guru.  “If you don’t have the time or the inclination to do this work, then I’m begging you, please don’t try to invest in individual stocks.”  (Emphais added.)

Who said that?  Vanguard founder John Bogle?  No, it’s Jim Cramer, who pounds the table for individual stocks amid the booyahs and silly hats on his weekday Mad Money show on CNBC.

“Investing is fun for a lot of people, and if they want to try their hands [at stock picking], they should go for it,” says Peterson. “Just make sure that the majority of your portfolio is diversified.”

Gold’s observation is that the rest of us should “get our thrills and chills elsewhere.”

Conclusion

You can only achieve real diversification by investing in both stocks and bonds.  Moreover, within each category, you need to have many individual securities to be truly diversified.

Suppose you believe that your portfolio should include the following asset classes: large-cap U.S. stocks, small-cap U.S. stocks, large-cap international stocks, small-cap international stocks, stocks from emerging markets, and Real Estate Investment Trusts.  How can you possibly achieve this diversification without hundreds of individual securities?  In my opinion, you can’t, which is why you need mutual funds.

The portfolios I construct for my clients typically have mutual funds with thousands of securities.  That is diversification.