Tuesday, November 26, 2013

Why I no longer buy individual stocks

Every time I'm tempted to buy an individual stock, I have to remind myself that I shouldn't do so. Now, vast fortunes have been and are being made in individual stocks today, so it's not because you can't make money that way. Similarly, I've bought and sold individual stocks in the past, and even made money doing so, so it's not because I'm not capable of making money that way.

Here's the deal: the overall stock market is a representation of corporate earnings in the USA. Over time, that growth is very much predictable: you can pretty much count on a 3% annual real return. Back when inflation was 3%, that meant 6% a year. You might have heard about the average 10% growth per year, but I believe that's excessively optimistic, and a result of bad math. For instance, if your portfolio dropped by 50% one year and then grew by 30% for the next two years, your portfolio would end up around 84% of where it was at the start of year one. In other words, it takes much more growth to overcome a big down year than simply taking the arithmetic mean of the growth would imply. The entire market is quite capable of doing such big swings, as most of us who've lived through the 2001 and 2007 crashes know.

An individual stock is even more volatile. Yahoo! for instance gave us quite a ride over the last 10 years, and is right now regaining the peaks it achieved in 2005, during the proposed Microsoft buyout. Is this because new CEO Marissa Mayer is going to jazz up the earnings? No, not really. It turns out that Yahoo's Alibaba stake is what's causing Yahoo stock to go up. So taking a bet on Yahoo is like taking a bet in the pre-IPO Alibaba. And in case you do want to bet on Alibaba, you should know that Yahoo's stock has already been bid up because of this!

In any case, I have no idea where Yahoo is going to go, and neither do most folks. Since that's the case, I have no business owning the individual stock. It gets even worse when it comes to stocks that you think you know something about, because that's when it's very easy for you to get caught up with the story you want to build and ignore poor performance. For instance, many techies hate Microsoft, and would want it to fail. Yet there's an argument to be made the Microsoft could be the next Apple. Don't believe that slide deck? Neither do I. Then again, I didn't want to believe that Apple would be the next Apple, since my personal bias is that the world would be better off if Apple didn't exist. (I bought Apple at $9/share and sold it at $50/share after deciding I couldn't trust Steve Jobs)

There is one stock I exempt from this rule, which is Berkshire Hathaway, which I consider to be a mutual fund run by Warren Buffett. During the 2008 crash, I found myself buying in, because the economic environment was one that Warrren Buffett is known to do very well in. I was right. But even then, I have a lot of trouble figuring out what to do with holdings now. Buffett is now very old, and who knows if he will kick the bucket soon, at which point I'll take a loss. So even in this case, I have my doubts as to whether what I did was wise.

The big difference between investing and gambling, therefore, is having a long term plan in place, and sticking to it. That's why despite all these stories about stocks being about to crash 40-55% (which I can believe in), I'm still sticking to my asset allocation. As John Maynard Keynes writes:
I would say that it is from time to time the duty of the serious investor to accept the depreciation of his holdings with equanimity and without reproaching himself.
Now this quote isn't relevant because everyone will lose money at some point or another. It's also there to remind yourself that the discipline to stick to your asset allocation is important, and overrides any desire to outsmart the market or yourself. The problem comes if you don't have the discipline, which then behoves you to hire someone else to drive the car while you get drunk.
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