Good and bad reasons to invest in individual stocks rather than index funds

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Hi everybody! I’m back from a two-week blogging hiatus! Things got busy at the office right before I left and we also had to prepare for our road trip and ERN Family World Tour, currently in beautiful New Mexico and moving on to Texas soon! I was amazed at how little work I got done while traveling! Early retirement is a lot more work than I thought!

IMG_0523_small
In Pecos National Historical Park, New Mexico.

In any case, today’s topic has been on my mind for a while: What would be reasons to hold individual stocks? Not all but the majority of folks in the FIRE community apparently favor just plain passive index investing and I have been an index investor myself for the longest time. But occasionally we should definitely question our assumptions. Especially those that sound like the good old “We’ve always done it this way!” And one “excuse” to look into this topic is the ChooseFI podcast featuring Brian Feroldi a few weeks ago. Brian talked about his adventures as a stock picker! I thought it was a great episode, though, of course, I didn’t agree with everything. But it got me thinking about what would be good reasons and what would be not so good reasons for me to abandon my index-only approach. Let’s look at my favorite eight…

Bad reason #1: I’ll beat the market

As many smart people before me have pointed out, all active stock pickers in aggregate (!) can only at most generate the market return. That’s because the market overall has exactly the cap weights (by definition) and when you take out all the passive indexers (who also hold exactly the index weights, by definition) then what’s left for all the non-passive investors is also distributed exactly according to the index weights. Take out the cost (both time and monetary) for researching stocks and the stock pickers will likely lag behind. Again, at least in aggregate!

But even among the stock pickers that – against the odds – manage to beat the market, the outperformance may not be due to skill at all. Here would be three reasons why someone could have outperformed the market with no skill involved whatsoever:

  1. Luck: Ten monkeys throwing darts at a board with stock tickers will, on average, match the index. Around five of them will beat the market and the remaining monkeys will underperform. Statistical tools are necessary to sort out whether someone was skilled or just plain lucky.
  2. Sector and/or style bias: Lots of investors beat the market all the time. I’m sure that everybody who was heavily invested in IT stocks would have outperformed the market over the last few years. So, imagine the IT sector outperformed the market by 5% and a stock picker who’s heavily invested IT outperforms the market by only 4%. Would I call that person good stock picker? Probably not! You could have just bought a sector ETF and done better! Similar issues arise when investors take other significant departures from the market weights, e.g., value/growth tilt, small-cap bias, etc.
  3. Beta bias: Everyone can beat the market over the long-haul. Just use leverage! One can use leverage explicitly, which is quite easy and inexpensive if implemented with futures (see this old vintage post of mine on the Synthetic Roth IRA). Or by overweighting “high-beta” stocks, i.e., stocks that are more responsive to market moves than the average. So, if someone has a portfolio beta of 1.4 (40% more market risk than the broad index) but less than 1.4-times the market return it wouldn’t be skill at all despite outperforming the index! As we like to say in finance: outperformance due to beta ain’t alpha!

So, if people tell me that they beat the market I would normally offer to run a statistical analysis to quantify these three potential sources of outperformance. Without getting too much into the finance weeds, it’s called a factor model and it’s a standard tool in finance to (among other things) sort out exactly this question: determine whether there is any “alpha” (=outperformance) left after accounting for beta and commonly used styles (often value and small-cap, but the academic literature has come up with many more factors). And if there’s any outperformance, how statistically significant is it? So far, no one has taken me up on that offer. Maybe Brian wants to volunteer?! Send me your monthly %-returns and I’ll start cranking! 🙂

Bad reason #2: Lower fees

True, you will save the expense ratio of the ETF or mutual fund. But how much money are we talking about here? A $1,000,000 portfolio invested in index ETFs/mutual funds at Schwab (SCHB/SCHX), Fidelity (FSTVX/FUSVX), or Vanguard (VTI/VOO) will cost you $300, $350, and $400 a year in expenses for the standard broad U.S. equity index funds (both Total U.S. Stock Market and U.S. Large Cap).

However, once you factor in the time you spend on researching stocks (opportunity cost), the cost of newsletter subscriptions, trade commissions, etc., I doubt that you’ll come out ahead of the index investor (but note the caveat in “Good Reason #3” below!).

Bad Reason #3: Warren Buffett did it!

Warren Buffett seems to be the only stock picker not only spared the ridicule of the FI community but he’s even revered by us. And for a good reason because Berkshire Hathaway has definitely had a great run of outperforming the overall market. Then why do I call this Bad Reason #3 and not Good Reason #1? Well, here’s what researchers at a pretty well-known asset manager did: they ran a factor model similar to the one I mentioned above and found that a sizable portion of the Berkshire-Hathaway outperformance is due to leverage:

“One of the ways that Berkshire Hathaway was able to add so much return above that of the market is Berkshire’s access to cheap leverage via its insurance business, allowing it to harvest greater amounts of these style exposures than most traditional investors could.”

Out of the over 10 percentage point of excess return over the market portfolio, only 3.6% are due to “alpha” (skill) and that regression coefficient is also not even statistically significant. For us retail investors it means that without the benefit of owning an insurance company on the side we likely wouldn’t be able to get even close to replicating what Warran Buffett did. Even if we had done all the same work and brilliant analysis as Buffett and were able to hold those same stocks (which is also impossible because of some of the private, non-listed holdings)! The best way to replicate what Buffett is doing is to simply hold BRK-B in our portfolio.

Bad reason #4: I will invest only in stocks I know

I think that’s a horrible reason. Most folks following that strategy will inadvertently introduce a significant bias into their portfolio. You may know certain stocks very well because of the industry you work in. But I would have never invested in financial equities beyond their index weight because they are highly correlated with my wage income. Others hold companies that they like to frequent as consumers. You’ll likely introduce a significant bias to consumer and IT stocks and are underweight Industrials and Materials. Even if you manage to outperform the index you will probably do so at the cost of much higher volatility! In any case, I looked through the list of S&P500 stocks (there are actually 505 of them, go figure!) and there were tons of stocks that I never heard of before. And that’s for the 500 largest stocks. If we go to mid-cap or even small-caps I would probably know hardly any of them! And I love it: I hold stocks I didn’t even know existed! You can’t get much more diversified than that!

 

So much for the bad news. Let’s move on to four good reasons!

Good reason #1: Tax loss harvesting

I like Tax Loss Harvesting. It’s a neat little the tool that may add a few extra basis points to the after-tax return. And it’s more effective if one can do that on the individual stock level, not just on the stock index level. Look at the following simple example to illustrate this point. Imagine, for simplicity, an index has 5 stocks and they are equally weighted. Imagine I have two options: invest $1,000 in each of the individual stocks or $5,000 in the index. Imagine also that there is some dispersion across the five stocks. Specifically, the individual returns are -4%, -2%, +/-0%, +2% and +4% in addition to the median stock (=index) and of course no one knows in advance which one of the five stocks will under or outperform the index. So, if we calculate how much in tax losses we can harvest as a function of the index return between -5% and +5% we notice that holding the individual securities generates more in tax losses. All the while the pre-tax returns are the same.

TLH Example Table 01
Tax Loss Harvesting Example: Investing in individual securities yields more taxable losses than investing on the index level. ($1,000 invested in each stock vs. $5,000 invested in the index)

The biggest difference occurs when the index is flat. In that case, there is clearly no tax loss for the index investor but the stock investor can still harvest the losses of the two “underwater” stocks! Holding individual stocks will generate more tax losses unless we find ourselves in one of the two extreme events where either all stocks underwater or all stocks gained!

TLH Example Chart 01
Same data, but displayed as a chart.

And for full disclosure, this is not an endorsement for any of the (for-fee) Robo-advisers. Quite the opposite, the few basis points in extra return don’t justify the 25 basis point (0.25%) annual fees that Wealthfront and Betterment charge. You will never find an affiliate link for those guys on my blog! Instead, just do the tax loss harvesting yourself with only a minimal amount of work, check my blog post from a long time ago on how to be your own Robo-adviser!

Good Reason #2: More tax-hacking

In my last post from two weeks ago, I pointed out one little “flaw” in the index-only investing strategy: investors in a high enough tax bracket will be hit with taxes on dividends in the accumulation phase: 15-20% marginal on the federal level plus 3.8% Obamacare tax plus state tax (if applicable). Those taxes are assessed every year and compound over the years! So, even if you don’t like to deviate from the index weights you could benefit from constructing your own U.S. large-cap index portfolio from scratch and then putting the lowest-yielding stocks in the taxable account and the highest yielding stocks in the tax-deferred accounts. One would then avoid compounding the dividend tax bills in taxable accounts. I proposed that this could be easily implemented with an ETF but until Vanguard, Fidelity, Schwab, iShares, and State Street step up to the plate one would have to do this manually with individual stocks!

Good reason #3: It’s fun and it will keep me engaged and motivated

Investing is for the long-run. Even early retirement will take 10-12, maybe 15 years to achieve for most of us. How do you get excited enough to start this journey and how do you stay focused and motivated along the way? I have the impression that for a lot of FI bloggers, investing is mostly a means to an end. Investing is boring! There’s even a GoCurryCracker blog post with that title. I have no problem if people want to make investing boring. But I think that there are many among us that are truly excited about investing. I would count myself in that group, though I’m more excited about investing from a macro perspective, less about stock picking. But if Brian wants to subscribe to a stock newsletter, more power to him! He seems to really enjoy reading updates about companies. It’s like Brian is reading People Magazine, but with stocks! Can’t we all agree that this a more productive use of his time than reading the actual People magazine?

And here’s another example: how will I get my daughter excited about investing? She’s only four right now so this discussion is still a few years in the future. If the time comes in a few years then, sure, I could tell her “Hey, kiddo, I bought you one shiny share of VTSMX and sorry, VTSAX is only available for accounts $10,000 and up!” Maybe she’ll get really excited about that. But I suspect a Total U.S. Stock Market Fund is a bit too abstract for a young kid. Compare that with giving her a share of Disney or McDonald’s, two companies she really, really likes even now at only four years old (God bless America!). Maybe even give her the actual stock certificates, framed to hang in her room (even though I heard that getting the physical certificates is not easy anymore). That might be a lot more impactful for a kid!

Good Reason #4: Some prefer a style that requires weights different from the index cap weights

OK, so now we are wading into territory that might spark some controversy. But here would be a few reasons to deviate from the market cap weights and the implementation may (or may not) involve holding individual stocks:

  1. Dividend-tilt: Overweight stocks with a higher dividend yield, for example, to generate income in (early) retirement. Some bloggers swear by it (Ten Factorial Rocks, Tawcan, etc.) and I must say I’m also warming up to the idea. Some of the high-dividend-yield funds get close to or even match the 3.25-3.50% withdrawal rate I’m targeting. The thought of not having to dig into principal during early retirement is certainly appealing!
  2. Sector tilt: Overweight and underweight certain sectors or even certain individual stocks. For example, if you work in a specific sector or for a specific corporation, you under-weight that specific stock/sector so as to not double up on the sector risk or idiosyncratic company risk.
  3. Beta tilt: As a risk-control, one could overweight stocks that have “low beta,” that is, lower exposure to market risk. There’s even a very well-known research paper, aptly titled “Betting Against Beta” that showed that low-beta stocks tend to have better risk-adjusted returns. And the same phenomenon also holds in other asset classes!
  4. Equal-weighting (as opposed to market cap weighting): Past returns show that equal-weighting would have outperformed the cap-weighted index. See, of all places(!!!), a link at Bogelheads, with returns going back to 1971. What I like about equal-weighting is not even so much the past outperformance because there’s no guarantee that this will carry over into the future. But the risk, specifically the idiosyncratic equity risk, is spread out more equally than with market cap weights, where the top 50 stocks in the S&P500 account for only 10% of the names but 50% of the market capitalization!

Admittedly, some of these can already be harvested through ETFs. For example, there are a number of High-Dividend ETFs or sector ETFs. Equal-weight ETFs have been around for a while as well. But the more exotic the ETF the higher the fees, for example, 0.35% for the “Dividend Aristocrats” (NOBL) and 0.30%+ for most equal-weighted ETFs. That could already entice some of us to simply replicate the whole thing with a number of individual stocks. Also, to my knowledge, ETFs haven’t picked up the exact “betting against beta” theme yet, though some ETFs exist in a related space: Vanguard, Fidelity and iShares all have “‘low-volatility” ETFs. While vol and beta are related there’s a subtle difference between the two, of course!

Summary

I’ve been an index investor my entire life. But I will explore investing in individual stocks going forward. Not necessarily because I have any illusion that I’ll be the next Warren Buffett but mostly because I like to shift some of our equity portfolio into the low-beta, high dividend and equal-weighted direction and do some additional tax loss harvesting. To keep transactions costs as low as possible I will likely use M1 Finance (affiliate link), a new online brokerage that offers commission-free trades and trading fractional shares of equities and ETFs! Stay tuned for updates on how this goes!

I hope you enjoyed today’s post! Please leave your comments and suggestions below!

Title Picture Credit: Wikipediahttps://www.tradergroup.org/

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74 thoughts on “Good and bad reasons to invest in individual stocks rather than index funds

  1. I also have chosen the index route,mainly because I lack the time and interest to do individual stock.

    I do options on individual stock, more for the fun and excitement to compensate the boring indexing and to keep it boring.

    I like the idea to offer some stock to the kids of brands they like to ignite an interest.
    Enjoy the world tour!

    Liked by 1 person

  2. Index investing is great but it shouldn’t become a dogma. It is very healthy to know about its shortcomings and how we can take advantage of other investing styles. Index funds were started by contrarian thinking, not by following what everybody else was doing. We tend to forget that it is still our job to find the best solution for each of us considering our personal situation. Thank you for making me think!

    Liked by 2 people

  3. We may have found a way to turn a bad motivation (believing we could beat the market) into a good thing (even though we were definitely not able to beat the market). Last year we received an unexpected windfall from selling our house, but were fearful about lump sum investing into a highly valued market. We ended up feeling more comfortable buying a mix of individual stocks that were trading at much less of a premium and often had large dividends. Not surprisingly we had a mix of market beating picks and loser picks. But at least it stopped us from leaving a bunch of money in cash for the back half of 2017. I have also found following individual stocks and the associated research to be a lot of fun in limited quantities.

    I am looking forward to hearing about M1 after you have some experience there. No fees ever sounds a little to good to be true. But it would be amazing to park the “play money” somewhere that doesn’t charge for each trade, and I am happy to tune out side bar ads if that is all it takes.

    I would also love to see a future post on a dividend tilt portfolio and any thoughts you have on how to avoid the stocks that are playing games with finance and accounting tricks to keep a high (and potentially unsustainable) dividend.

    Liked by 1 person

    • Thanks for sharing that experience! I never thought of that as a motivation to buy individual stocks, but it makes perfect sense! It can definitely alleviate some of the fear of plunging into the market with a big lump-sum!
      I will also post some of my ideas on avoiding high-dividend traps in a future post! 🙂
      Cheers!

      Like

  4. Have you looked at using historical CAPE for the different sectors with guardrails of %. So when Tech is historically high CAPE you underweight and increase weighting in another sector when their CAPE is lower? Or breaking it out with Value, Growth, Small, Large, etc?

    Liked by 1 person

  5. There is another advantage I would like to add to your list, especially for all the younger people out there pursuing FI. When we finally experience a major dip in the market, it will test the nerves of people who can sell VTSAX with one click. If you have a large number of individual stocks, you are more likely to stay the course, just like holding a rental home through 2008. The harder it is to sell, that may turn into an advantage. We shall see. The emotional side of investing matters as well.

    Liked by 3 people

  6. I’m an index investor today. Most research shows it will produce higher returns and take up very little time.

    I thought that the Choose FI episode on stock picking was interesting. I was hoping that Brian would get more pushback on what felt like very questionable points. It would be fun to have heard him and an index investor debate the merits.

    You hit the nail on the head with the pros and cons in this one. If I do start picking individual socks or more focused funds, these will be the reasons why.

    I’ve been debating the “buy individual stocks for kids” thing a little myself lately. I love the idea of buying my son a share of Disney and explaining that he owns it. On the other hand, does that approach increase the chances he becomes a “gambling stock picker” rather than a disciplined long-term investor?

    Liked by 1 person

    • Ha, good point! At some point, one would have to make the pivot toward diversification, of course. But maybe kids will learn that lesson all by themselves when they see how volatile a portfolio with 2-3 stocks can be. 🙂

      Like

  7. I’m new to your site and I think it’s great!

    However, I question the ability of most folks (including myself) to do individual stock tax loss harvesting. I’m not saying individual stock tax loss harvesting isn’t possible but I think you’re making it sound easier than it is. Coke is not substantially identical to Pepsi which is why you can harvest between the two without the IRS getting upset. Sometimes you’re going to harvest your PEP loss just to then get a KO loss and miss the PEP rebound. If you’re swapping VTI and SCHB it’s easy but if you’re swapping KO and PEP I think it’s more challenging. Add to this you’re intentionally choosing to sell when the stock you hold is down and buying an alternative that may have a weaker correlation than you think. The detailed analysis of when to swap KO/PEP (3% tax loss? 5%?) and the analysis of what would have happened over the last few year starting with KO or PEP is an exercise left to the reader…

    I also worry about the education value of stock picking for kids as Jason mentioned. I had some nieces and nephews pick AAPL and NFLX a few years ago and crush my diversified portfolio. I’m not sure that taught them the lesson that I wanted to teach them.

    I’m also in the process of doing some of my own tax account re-location (not reallocation) and definitely think that’s important but as you say you can do it without necessarily going to individual stocks.

    Once again, love the site, I have a lot of reading to do on all the fantastic material you’ve put out here!

    Liked by 1 person

    • True, TLH is not that simple with individual stocks. To avoid a wash sale you’d have to hold a different security. I’d pick one in the same sector, hopefully even same sub-sector. I can see how that can create mistracking and I can see how that’s potentially a bit of work. I think the mistracking is less of a concern. Sometimes the mistracking goes in your favor sometimes against you. It will average out over many years/decades/stocks. Check out this post:
      https://earlyretirementnow.com/2018/04/18/emergency-fund-in-stocks/
      and look for the two paragraphs “1) Magnitude” and “2) Sample Size” and this same argument works here again. 🙂

      Like

    • JKBrennan77: As I read in a book decades ago: “How to tax loss harvest”.

      If you still believe in the stock you want to TLH, double down and sell the original shares 31 days later. If the stock bounces back, you’re now “trimming your position” instead of tax loss harvesting. If the stock stays flat or moves only a little, you’re able to harvest the loss yet maintain your position.

      If the stock plunges over the next 30 days, you need to rethink your reason for holding the stock.

      Now you can get really fancy. You can double down and set a stop loss in case you misjudged and the stock moves against you big time. You can buy options around your trade to limit your downside. (I question whether this is worthwhile if you’re not running a hedge fund).

      But the point is, you don’t have to trade KO for PEP. There are ways around it.

      Good luck, and thanks for bringing this issue up. I have hard enough time swapping among ETFs, never mind individual stocks.

      Liked by 1 person

  8. Pro #3 is the big one for me. We have our 401k and taxable accounts in low-cost passive funds (Not all market-cap weighted, but they are of similar ilk), but we invest our Roth accounts in 3 similar, but slightly, different strategies revolved around value and momentum.

    Do I think people need anything beyond a few index funds? No. I myself really enjoy investing. From macro, down to company selection. I find it fascinating, fun, challenging etc. So I do it.

    I would advise that anyone interested in Pro #4 really needs to do their homework first. A few examples:

    1. Dividend investing seems to be lackluster when compared to a total return approach, especially with more and more firms deciding to pursue the more tax-efficient buyback strategy over issuing cash directly to shareholders. Withdrawing 3.5% from a total return oriented portfolio is no different than withdrawing 3.5% from a dividend oriented portfolio, with the added kicker that over time, historically of course, the total return approach has had higher total returns. I understand that their is a behavioral benefit to a more cash-flow oriented investment strategy, which is fine with me, but something to think about before jumping in.

    2. Low beta and low volatility investing has a great appeal, but remember that those strategies produce lower returns historically compared to the market. There risk adjusting returns are better, but not their isolated returns. The AQR paper applies leverage to the lower beta deciles, bringing up the volatility/beta of those low-beta stocks to match market volatility. That is how they get the returns higher than the market. Again, just something to consider.

    3. Equal weight is just a size tilt. Load up Portfolio Visualizer and compare RSP (Equal weight) to a portfolio of 60% VO (mid cap) and 40% VV (large cap). You will see the equity curves are basically identical in movements. From 1994-2017 the returns/volatility of the above portfolios were 9.55/15.87 and 9.61/14.92. You can test it out for yourself, but the numbers (and theory) are clear.

    Thanks for the write-up!

    Liked by 1 person

    • Correction in language: dividend investing as been subpar compared to similar total return “value” types of investing.

      Like

    • Very valid points!
      The low-beta strategy would have to be done in the context of the overall portfolio. So, instead of doing a 60% stocks, 40% bonds portfolio you’d do an 80% low-beta, 20% bonds portfolio.

      About the equal-weighting, I’m not going to replicate the RSP because I dont want to hold all 500 names. Maybe equal-weight 100 names. But I agree that this will introduce a small/mid-cap and value bias (see Arnott et. al. paper from 2013: https://www.researchaffiliates.com/en_us/publications/journal-papers/p_2013_aug_surprising_alpha.html).
      Hence my warning that this is less about outperformance and more about spreading the idiosyncratic risk more evenly so that the top name doesn’t have 3% but only 1% of the weight. EW will also have a low-beta tilt which I like.

      Like

  9. Another Good reason to prefer individual stocks or particular sector ETF is ethical, religious motivation to avoid particular sectors or particular companies.
    For examples some individual investor don’t want to invest on Oil & Gas, Alcohol, Gambling, Tobacco or Weapons providers .. Picking Stock allow you to granularly select the companies you desire base on your own assessment .. Granted this may lead to under-performing the Index or higher fees but your moral is driving this decision not your pocket.

    Liked by 1 person

    • Good point! Never thought about that! Some folks have strong feelings about what some corporations say and do (or don’t say and do). There are some ETFs and mutual funds with ethical tilts but they are expensive!

      Like

    • That’s a great point. Stock/index investing is, in the end, buying pieces of companies. Most people don’t want to be part owner to something they think is horrible, but end up doing it via indexes because there’s no strong reminder of what they’re actually doing. I’m sure when people open up Chrome they’re not thinking “I own part of the company that makes this!”.

      Liked by 1 person

  10. For me, it is good reason #1 & #3. I like selling off losers in December and I like looking and feeling like I am in control (illusion, I know) but also because I do not automatically reinvest, I let dividends build up and at the $300-500 mark I choose one stock I consciously want to double down on, more control and more focus in the build up phases.

    Liked by 3 people

  11. we’re not all chasing maximum returns, particularly once we’re done with accumulation. For me, I like to have a bit more of the returns distribution from the boring stuff (regulated utilities and the like) in the mix. If it keeps up with inflation over the long term with limited downside risk, that’s good enough for me.

    Liked by 1 person

  12. Interesting post. The ChooseFI episode was thought provoking and challenged the status quo. For that reason alone, I liked it. This pulls out a couple of things I find particularly interesting.

    1) Tax loss harvesting, it would be interesting to see how much of an impact this could have. Could this be used as a tax avoidance strategy during withdraw? Wouldn’t tax loss harvesting beyond the amount you would expect from the index shift your allocation of individual stocks away from the index?

    2) Different index weighting, I find it interesting that you may be able to combine this with tax loss harvesting. I do wonder what would happen as the portfolio drifted away from the index / weighting you started with and if that would be a bad thing.

    Seems like it may be worth exploring some of this in a simulation.

    Liked by 1 person

    • Thanks!
      1: TLH can be used to offset $3,000 in ordinary income per year. So one could do a little bit of extra Roth conversions through that in retirement.
      2: I wouldn’t be too worried about weight drift. During the accumulation phase one could simply direct the dividend income and new savings to the under-valued stocks. In retirement, simply withdraw from the overweighted equities first.

      Like

  13. I’m big on the dividend tilt and on weighting my allocation by % of income generated (rather than % of holding). My goal is to be able to retire on dividends and never touch the capital (I have plans for that money in a bequest).

    One thing that always perturbs me about index funds is the allocation of monies to stocks grossly overvalued by any possible consideration of their fundamentals and the allocation of monies to losers who still have sizable market cap but that I would never choose to buy.

    Investing directly in individual stocks, I can choose stocks that are a good value. In particular, I can choose solid dividend payers who are currently selling at a discount (high yield compared to their historical yields), especially when that discount is an effect of sector drag rather than a problem with that specific company. I maximize my value for dollar invested (measured in yield on cost, reliability of the dividend, and dividend growth prospects) while avoiding companies whose finance statements make no logical sense to me like Telsa and Netflix (negative 3 billion in FCF projected for 2018?!).

    If I were to invest in an S&P 500 index fund, I would be less diversified by both sector and overall allocation (even though I would hold more stocks) because of the cap-weighting. FAANG now makes up something like 11% of the S&P500. Netflix is just shy of 0.6% of the S&P500. I’d rather not sink a penny into Netflix at its current valuations, debt, and absence of a compelling pathway to profitability. Plus, of those, only Apple is potentially attractive as a source of dividends (and that is based largely on its dividend growth potential).

    The more other people are flocking to indexes, the less rational the market becomes, and the more opportunities there are for stock picking. In fact, even Bogle himself recognizes that there is a threshold at which index investing would break down due to the absence of active investors. Bogle said last year that at if the market was composed of 75% index investors it would create “chaos” and “catastrophe” in the markets. I expect somewhere far below that threshold is the point where indexing loses its advantage and ceases to be the rational investment option.

    And remember: past returns are not predictive of future returns. That includes the backtesting of index funds vs. other strategies. Just as there may no longer be a small-cap advantage, we may also be entering a period in which there is no longer an indexing advantage.

    Liked by 3 people

  14. good grief. Prof Hendrik Bessembinder found that just 4% of all stocks that have existed generated 100% of the total return to the US stock market over time. In other words, 96% underperformed, nearly half of those lost money. I don’t think a 4% winning % or better expressed, 96% failure percentage, is the way to go buying individual stocks. Only for rubes.

    Liked by 1 person

    • The headline on the Bessembinder study is a lot more dramatic and dire than the full study findings. You can download the full study from SSRN (link below), but in short, the reason for the 4% is that half of all stocks die out (are delisted) in about 7 years. Bessembinder studies something like all 25,000+ stocks that have ever been listed since 1926 or so and finds a little over 1,000 stocks account for the gains. That’s your 4%. The other 24,000+ losers? A large number of them are risky micro and small cap stocks, companies that never showed a profit, internet IPOs, etc. In short, companies that would never pass a value screen.

      In fact, Bessembinder notes that the 4,138 stocks in his study that are “still trading” (of the >25,000 he looked at) “most often generated favorable outcomes.” When he names specific stocks that outperform, they are pretty much all dividend-paying stocks and many are dividend champions and aristocrats.

      Remember: the Vanguard “total stock” ETF (VTI) has just about 3,600 stocks in it. That’s only about 14% of all the stocks in Bessembinder’s study and it has no screen to prevent including stocks with negative earnings, or other red flags for failure that Bessembinder notes.

      Part of the lesson of Bessembinder is that you can use survivorship bias to your advantage when investing. A company that has been around 50 years and paid dividends for 20 is much more likely to be around and paying dividends in 10 years than a company that has only been around for 5 years. And that’s before you even dive into their fundamentals. Bessembinder indicates that if you were to weed out companies with negative earning and companies brought to IPO when they are still quite young and small, you would weed out many of the losers, again easily increasing your chances of making sound investments.

      Yes, you will still get bit by a GM or GE, so diversification is still important (which is Bessembinder’s most central thesis: diversify!). That, and stay away from young, unproven micro-cap and small-cap stocks and especially stocks with negative earnings (looking at you, Helios & Matheson!). In short, don’t aim for the fences — focus on reliable base hits from long-standing dividend paying stalwarts of the market with sound fundamentals. And diversify!

      The other option, of course, is to just drop it all in a total stock market index fund and eat the losers, letting the winners balance it out. Of course, your dividend yield will be comparatively poor, but for some investors that does not matter. That’s ultimately Bessembinder’s recommendation, though there is nothing in his article that diminishes the soundness of investing in stable, established dividend-paying companies with sound fundamentals.

      Bessembinder study: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2900447

      Liked by 2 people

        • Dan: how myopic of you to fail to recognize the dogmatic, unsubstantiated, and ad hominen nature of your own comments. To start, you wholly misrepresented Bessembinder’s findings (or at least their implications). You received a thorough, sourced, and neutral correction to your bias. And then you chose to dismiss the helpful response flippantly. For you, absolutely: stick to indexing.

          Liked by 1 person

  15. ERN – Great post as always, I can’t wait to see you spend some more time on good reason #4. I’ve always had a special appreciation for dividends going back to the tech bust and accounting scandals of the early 2000s, you can only “fake” cash flow for so long as a company if you’re delivering monthly/quarterly checks to investors. I also think REITs and MLPs are a unique asset classes that needs to be included in the dividend portfolio idea. Enjoy your trip!

    Liked by 2 people

  16. ERN, great post. I’ve been reading a lot of your material lately and thoroughly enjoy it. From a personal finance perspective, it is great to have a healthy critique of traditional views. I don’t have any plans right now to do any stock investing, but I can see the benefit that comes with this and I appreciate those who are fleshing it out.

    If you make it to the DFW area, hit me up! I’d love to meet “The ERN” for a lunch or something. Or if y’all just need a place to stay!

    Liked by 1 person

  17. One other possible reason to pick individual stocks could be to follow an ideological and/or ethical investing philosophy that is not currently captured in any of the available Environmental/Social/Governing (ESG) index funds.

    Liked by 1 person

  18. I never had any luck with individual stock picking. On the other hand, I never invested into an index fund either. It seems so boring (to me) just to be stock piling into the same fund month after month. Hm, maybe I should give it a try nevertheless. It seems to be the most bulletproof way to reach your magic number. There’s just so many other exciting options at the moment, don’t you think?

    Liked by 1 person

    • Boring is good, FinanciallyFree! The more exciting it seems, the faster you should run away from it. Of course, I think long term 10% +/- returns are pretty exciting…

      Liked by 1 person

      • The things I invest in typically carry a 12-15% interest rate. The risk taken into consideration it will probably end up around 7-8% like the stock market average. However, knowing the business I invest in makes it a lot more exciting to me. Only time will tell if it’s a good plan..

        Liked by 1 person

  19. I suspect there’s been a degree of fake news from the indexing industry and financial advisers seeking straightforward options over the years. Anecdotally, most active investors I know in individual stocks have done quite a bit better than their indexing counterparts. It’s also satisfying and fulfilling owning shares in businesses you can identify and believe in.

    Liked by 1 person

  20. Karsten, I have questions regarding high yield stocks and ETFs. From what I can tell, high yield ETFs tend to have low price growth and overall less returns than a total return philosophy using just vanilla total market indices.

    But what if I have access to a mortgage-like product where the pre-tax high yield ETF dividend basically covers principal and interest repayments. Is this especially a “free” asset? Of course there are risks which I will ask you about later.

    My current strategy is to use all savings to invest in total market index ETF and start the put option selling strategy as I think those would have superior returns to a high yield ETF.

    But if I can borrow money with no margin calls and they dividends pay for the loan. I could get a bonus portfolio of assets?

    Risks I can see:
    1) Rising loan interest. If rstes rise to 10% interest rate, it is still manageable but it would divert finds away from other strategies.

    2) Dividend cuts. Same consequence as above.

    3) Cash flow management will be more difficult than it appears on paper because mortgage payments are monthly while dividends are quarterly.

    4) Price underperformance or even losses.

    Regarding 4), I’m not sure if this is the wrong justification but since it is a “free” investment, I will still end up with a dividend-producing assets which I didn’t pay for.

    Is it too good to be true?

    Liked by 1 person

    • I wonder what the low-cost loan is: Probably a mortgage or HELOC? I generally like leverage but there are the usual disclaimers about leverage. Also, are you sure that the loan interest is so low that the dividends (maybe 3-3.5% yield for some of the high-dividend funds) are enough to pay the interest of the loan? After tax?

      Like

      • Hi Karsten,
        https://www.vanguardinvestments.com.au/retail/ret/investments/product.html#/fundDetail/etf/portId=8210/assetCode=equity/?overview

        That’s the fund I’m thinking about which is yielding 8% pretax. I think maybe another risk would be that it would add undue concentration risk because I would e be very undiversified from my home country. I would be at the mercy of the economy in both working life and the portfolio.

        Nornay I get away from this by replicating a total world index where Australia is maybe 2% so I feel safe that all my eggs aren’t in one basket.

        You’re the smartest person I know and I was hoping you could poke holes in my “free roll” investment before I do something stupid.

        Hope you’re enjoying your holiday and thanks for replying even when you’re supposed to be enjoying yourself.

        Liked by 1 person

        • The 8% yield doesn’t guarantee an 8% floor on your returns. Also, this fund has currency risk. Even worse, the AUD tends to fall against the USD if there is a market drawdown. So, I would be very cautious with this fund.
          But I can still see the appeal of the fund: You may, over a very long horizon, be able to pay down the loan (P+I) and even if the ETF tanks, after the loan is paid off, every cent of the ETF that’s left is profit. So, maybe play around with some play money. Don’t bet the house! 🙂

          Like

          • You’re definitely right regarding 8% yield not being the floor because of capital losses and dividend cuts.

            Currency risk I don’t think is a problem because I love in Aus. I hope that’s right.

            So in conclusion, there’s no free lunch here. It’s taking a bet.

            Like

  21. Hi, ERN,
    I became disillusioned with mutual funds/ETFs in the taxable account when I got nuked around 2000 with massive taxable distributions on underwater positions. I hold individual stocks or tax managed funds so I can have some control over my tax destiny. Not only can I tax loss harvest, but I can avoid taxable distributions in the accumulation phase. I guess it is not an issue in retirement as you withdraw from your portfolio anyway.

    ERN, have you ever thought of doing a piece on Roth conversions, and whether or when they are truly worthwhile? I’m thinking of converting to the top of the 24% bracket, but part of me says HOW IS THIS DIFFERENT from losing 24% early in retirement in a correction?

    Thanks for your articles!

    Liked by 1 person

  22. I have both indexes and individual stocks. I have crushed so hard this year that it’s undoubtedly due to luck. My outperformance is so great (and short) that it’s pointless to analyze. Long story short, I went long $AMZN (basically a momentum thesis, that it’s been going up a long time and will continue to go up as long as it keeps on investing into itself) and $AMD (it didn’t make sense that the price didn’t increase in light of the struggles $INTC had) and $MJ (YOLO, this one is just for fun, but I’m in the black, so…)

    My current thesis is that trade war fears are overstated and that $MU is undervalued. I really feel it’s fun to be proven eventually right about companies that make a lot of money and have a bright future. We’ll see, my entry point is $44.50

    Liked by 1 person

  23. I own around 75 stocks and got rid of my index funds. The way I see it is when you buy an index fund, not only do you own a small piece of great companies, but also the bad companies. When you pick your own stocks, you are essentially creating your own fund with your best view of the future. You strip out the bad performers, so you will perform better than average.
    I thought this was a well thought out article and I do fall into the category of individuals that love investing in stocks. There are so many arguments against individual stock picking that the average person doesn’t believe that they can do it. And it takes time to build. It is possible and a great way to stay tuned into the world around you, while making extra money – I am currently beating the market this year by 15% points.
    Thanks for the article!

    Liked by 1 person

    • Wow, 15%? That’s impressive! Congrats and I hope this outperformance lasts. I can see that the more people become indexers the more of an incentive have to pick the “good companies”
      But I conjecture that prices for bad companies already reflect that information and most of us will not be better at identifying good vs. bad companies than the market already does. Just my 5 cents! 🙂

      Like

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