Indexing vs. stock-picking: You don’t have to choose sides

A discussion about personal finances can be a polite, congenial affair. Few people come to blows over insurance or budgeting. But some topics inflame financial passions, and one of them is investing. Fellow GRS e-scribe William Cowie encountered this a couple weeks ago when he advocated for investing in individual stocks in certain situations. I thought I would pass along a few thoughts of my own, given that 1) William cited the success he’s had with a newsletter from The Motley Fool (my employer for the past 15-plus years), and 2) my own portfolio has big holdings in index funds but also some actively managed funds and individual stocks.

This is a huge topic, with enough books written about the subject to create an entire wall of books. But for today’s post, I’ll question one of the main arguments against individual stocks, then conclude with a few parting thoughts. And as my posts have traditionally been sprinkled with cat pictures, I’m including this cool “peace” cat as inspiration.

People Aren’t Actively Managed Funds

The evidence is clear: Most actively managed funds underperform similarly invested index funds. The Standard & Poor’s Index vs. Active (SPIVA) mid-2014 report says that more than 70 percent of actively managed funds lost to their respective benchmarks over the previous five years. The cheerleaders of index funds have plenty of hard evidence to power their pom-poms.

This leads some to argue that if fancy-pants Wall Street fund managers can’t beat an index fund, then the average Josephine doesn’t have a chance. However, fund managers have to overcome hurdles that individual investors don’t.

First off, fund companies take money from your account to pay for running the business and buying fancy pants. The fees charged by index funds are much lower than those charged by actively managed funds, which gives the former group a head start, so to speak. According to the SPIVA report, the S&P 1500 index (a more comprehensive measure of the U.S. stock market than the S&P 500) earned an annualized 19.18 percent over the five years ending June 30, 2014; the average actively managed fund made 17.95 percent — a difference of 1.23 percent. Not coincidentally, that is just about the average fund’s expense ratio — i.e., the percentage of your account value a fund company extracts. In other words, higher costs are one of the reasons active funds lag index funds.

Investors in individual stocks, on the other hand, just pay commissions, which generally are $10 a trade or less. If those shareholders are true buy-and-hold investors — which is the right way to do it — that is the only expense they will pay to own a stock for years to come. To be fair, investors who subscribe to research services should also factor in those costs. But annual expenses for investors in individual stocks shouldn’t be anywhere near 1 percent.

Also, fund managers must deal with the flow of money in and out of the fund, which might force them to invest in ways they would rather not. For example, when the market tanks, fund investors collectively take out more money than they put in. This can force managers to sell stocks after prices have already plummeted, even though they would prefer to be buying when stocks are down. On the flip side, when the market or a particular fund does well, money pours in, and the manager is compelled to invest the cash after prices have already gone up. As a fund gets bigger, its menu of potential purchases shrinks; it can no longer invest in smaller companies because buying a meaningful stake could drive up the price.

Individual investors don’t have these concerns. They can invest in small and big companies alike as well as buy, sell, or hold based on their own circumstances and choices. They are not forced into selling because others are panicking.

Do these advantages that individuals have over fund managers lead to market-beating returns? The research is not as extensive as the “index vs. active funds” literature — and much of it is outdated, involves only a few years’ worth of investing, and/or is based on data from foreign exchanges. But I know of enough people who have pulled off benchmark-beating returns to know that it is possible.

Indexing and Picking Stocks, Living in Harmony

There is so much more to say on this; but for now, let me pass along these three thoughts.

1. Index funds are the right choice for most investors’ money. Even Warren Buffett, one of the greatest investors of all time, agrees. In the 2013 annual letter to Berkshire Hathaway shareholders, he revealed the instructions in his will for the money his wife will inherit. “My advice to the trustee,” he wrote, “could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.)”

2. This isn’t an either/or decision. Even some of the most ardent supporters of index investing are OK with people having 5 percent to 10 percent of their portfolios in individual stocks. One of those people is Bill Schultheis, author of “The Coffeehouse Investor” (one of my all-time favorites). He wrote: “Somewhere among the millions and millions of stock pickers you might be the next Warren Buffett. But I am not sure it is worth risking your entire portfolio to find out you aren’t.”

Many people who are known for their indexing advocacy own some individual stocks on the side. Heck, even Vanguard — the company most known for advancing the cause of index funds — has been offering actively managed funds for decades. Last year they published “The Case for Vanguard Active Management” and launched their non-indexy Global Minimum Volatility Fund. If Vanguard can be cool with an investor having both active and indexing strategies in a portfolio, then it’s probably fine.

3. Keep score. However you invest, evaluate your choices annually. Are your actively managed funds keeping up? Do you have the best index funds? If you have a financial adviser, how is she doing? If you are picking stocks, how are you doing? If you’re not sure how to do all that, have no fear. It will be the topic of one of my first posts of 2015. But beating an index fund is not an easy thing to do, so it is important to know sooner rather than later if your forays into active management are paying off.

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There are 18 comments to "Indexing vs. stock-picking: You don’t have to choose sides".

  1. NicoleAndmaggie says 13 November 2014 at 05:42

    Outdated? O’Dean’s work is still valid. People are still lousy at picking and keeping individual stocks. People still sell them too much, racking up fees, and at the wrong time for standard behavioral reasons. Small investors still cannot diversify enough to justify. Yes these problems aren’t important when it is 10% of your portfolio, but that is not what Cowie was arguing at all.

    And I know as many people who have lost money they couldn’t afford to lose on individual stocks as you have who have “beat” the market. You probably do too, even if they don’t tell you about it. Buy and hold doesn’t work when the company goes out of business.

    • Beth says 13 November 2014 at 06:07

      I know people who own individual stocks — but it’s the dividends they are after so the value of the stock doesn’t make as much difference. I’m wondering if I should be looking into dividend paying stocks too.

      • nicoleandmaggie says 13 November 2014 at 07:20

        I own PG&E (a legacy single stock from my father). It provides a nice dividend now. But it also went bankrupt while I owned it (which would have spelled death for say, a tech stock). There’s a lot of volatility in individual stocks, *even* supposedly low-risk big utilities.

        Is it beating the market? Is it doing better than a dividend index fund would? That entirely depends on when you bought it and how long a period you’re measuring. That’s because of volatility. I’ll never know how well it did for me until I decide to sell it. (And if I sell it when it’s a “loser” as suggested, I won’t make as much money as if I sell it when it’s a “winner.” Are you supposed to sell losers or to buy low sell high? Not something you need to worry about with a fully diversified index portfolio.)

        My father spends hours pouring over value-line– it’s a hobby. But I’m not sure that he does any better than my Vanguard index portfolio.

        Another aspect is taxes. It is a huge PITA to deal with taxes for individual stocks– buying now means that you know their basis (since online brokerages are required to keep that information), but for older stocks, you have to have kept meticulous records. And there’s splits and bankruptcies and buyouts and all sorts of really annoying things that require extra forms and research. I have one single AOL stock (also legacy) because untangling the Time-Warner/AOL gyrations is just too taunting and not worth the $45 minus taxes I would gain from selling it. (Etrade thinks I paid $0 for it… pretty sure that’s not true.)

        Evolvingpf’s post here has something to say on the topic: http://www.evolvingpf.com/2014/11/consider-source/

      • Some Guy says 14 November 2014 at 05:01

        Beth, I think it all depends on what your goal is for your investments. Most people have the goal of building a large “nest egg”, then being able to live off of this money. This is the traditional way to retire and is what most retirement advice is built around. Of course the down side to this approach is that once you retire you usually have to start liquidating your investments, selling the shares you acquired over the years to generate the money you need to enjoy retirement. If your investments take a big, unexpected hit at some point (such as a major market correction) there is a serious chance that you may come up short unless you had built such a large nest egg that you can absorb the huge loss and wait for the market to recover.

        DGI (Dividend Growth Investing) tends to pursue a different goal. To me the size of my “nest egg” is less important. If my stocks never go up in price I am still rather happy, perhaps even happier. Why? Because what I am after isn’t a large nest egg, but a stream of constant income that will someday allow me to enjoy retirement without the need to ever sell a single share between now and the day that I die!

        When I invest I look for companies with at least a 10 year history of annual dividend increases. Some of the 18 stocks I currently own started their dividend increase streaks over a decade before I was even born. I tend to spend an hour or two each week scanning through the headlines about my companies. I ignore most of the articles as a form of “white noise”. The opinion pieces about why stock X is “good” or “bad” and the press releases about how product Y is even greater than the invention of sliced bread aren’t all that important. Instead I look for articles about what is really happening with my companies. The latest “same store sales” figures for one of my retail stocks or the latest quarterly earnings estimate are what are truly important. I weigh whether bad news is a short-term trend that has a good chance to turn around in the next couple of years, or a sign of serious long-term problems that may indicate it is time to shift my investment capital to a better investment (something I rarely end up feeling the need to do.)

        The two major advantages to this strategy are first that a good dividend portfolio means you don’t have to sell your shares to generate money to live on. Secondly a good portfolio of dividend stocks not only pays enough to survive, but the companies’ dividend increases (if you’ve chosen a good mix of investments) match or exceed the rate of inflation, so your retirement income hopefully continues to meet your needs going forward.

        The “risk” from this approach is that a company might freeze or cut its dividend when times get tough. By limiting my investments to companies that have shown a willingness to continue to maintain and grow their dividend payments even through multiple recessions I reduce the risk of this happening. And by spreading out my investments over a number of companies that meet this criteria (I have shares in 18 companies today and hope to eventually get up to between 40 and 50) I hope to build a broad enough portfolio that even a couple companies being forced to cut their payments can be absorbed. After all, a company’s decision to cut its dividend doesn’t eliminate the capital value of their shares. I will simply sell that position and use the money to replace it with dividend income from another company to offset the lost income.

        One thing that drives my reasoning is the fact that my wife, who is almost 9 years younger than me, is likely to outlive me by quite a few years. When I pass on, my portfolio will continue to make its payments to her and I have every reason to expect that a stream of retirement income that was enough for two to be comfortable will easily be enough for just one. And when she eventually passes on, the portfolio will probably go to our nieces and nephew since we have no children of our own. Hopefully they will have the foresight build upon it and use it to help them retire many years from now as well.

        • Jerome says 17 November 2014 at 02:18

          Exactly how I manage my nest-egg. But only after a long school of hard-knocks. I have doen it all, trading, stock-picking, selling too early, dabbled with futures and quit a lot of option-trading. But all that time I had in parallel a very boring dividend-oriented portfolio for our kids. And it outperformed my own portfolio from 2001 onwards, so that in the end end I switched 95% of our nest-egg to dividend-growth stocks. 5% I use to play the stock-market, for fun and to stay active.
          There is one additional aspect of investing in individual stocks which should not be forgotten, and that is that it is much easier to learn from the mistakes you make yourself being individual stocks than from the performance of the overall stock-market. So investing in a index tends to be VERY passive.

        • Some Girl says 20 November 2014 at 06:52

          Some Guy,
          Thanks for the informative response. What would be a very good way for me to learn more about the “How-to’s” of DGI? Thank you, Amy

        • Krishanu says 23 December 2014 at 15:27

          Or you can invest in the two Vanguard ETFs, Vanguard Dividend Appreciation ETF (VIG) and Vanguard High Dividend Yield ETF (VYM) [both with ER of 0.10%] which will do the same thing for you, but spare you from “actively” reading about and taking actions on stocks which do not meet the criteria.

    • Robert Brokamp says 13 November 2014 at 08:45

      It does seem Odean is the academic most known for doing this kind of research, but I would like to see more recent studies of U.S. investors, given how much easier it is for the individual investor to buy stocks compared to, say, the mid-90s. Maybe I haven’t looked recently enough to find it (feel free to pass along links!).

      But most important, make sure you visit his site (http://faculty.haas.berkeley.edu/odean/) and hover your mouse over the picture on the right.

  2. Beth says 13 November 2014 at 06:04

    I really enjoy and appreciate articles like this! I can’t speak for others, but I’m getting past the point of “how to save money on x” type articles — but tell me how to save money on investment fees and you’ve got my attention. I think GRS is well served by focussing on quality content rather than comment bait.

    I hope you’re sticking around, Robert!

  3. getagrip says 13 November 2014 at 06:29

    I have purchased and sold individual stocks and beat the market in those individual purchases. However it was after a substantial amount of research and I had to hold one stock much longer than I wanted which had me sweating and left me not wanting to bet so much on one horse again. Point is, it does take a fair amount of effort and is not something you do by playing hunches or following someone’s tip of the month. IMHO most of us don’t have the inclination, interest, or time available to do a good job at it and therefore index funds are the best bet with the least amount of worry.

    Currently the total of my investments are in index funds for the above reasons. However I am starting to save a small amount on the side with the idea that I can use it to invest and to actively manage some years in the future. How much of the total portfolio that becomes depends on how well I do with the small amount over time. It may stay nothing more than a minimal hobby or it may become a consuming passion or I may just chuck it all and stick with index funds.

  4. C Joyce says 13 November 2014 at 07:47

    Sheeesh! I am an index fund type. I have a bro-in-law whom fancies himself a day trader, we only ever hear about the wins! I do not have the time, money or temperament to read all those tip sheets or hunker over the computer for hours a day. We are doing fine with Vanguard. If Warren likes it, that tells me something’. Just keep dollar costing in and stay the course

  5. Matt says 13 November 2014 at 08:16

    The $10 commission fees really start to add up if you don’t have a huge bankroll and you’re attempting reasonable diversification.

    Also, the reason individual stocks aren’t brought up much in the index vs actively managed fund debate is that you can’t buy individual stocks inside a 401(k). Which this article glosses over.

    Furthermore, the forced to sell comment does not hold true for index funds. When you buy a share, you get a fraction of each company on the index. There’s no moving money around to cover in/outflows of cash. You know exactly what you’re getting and exactly what it’s worth.

  6. Kurt @ Money Counselor says 13 November 2014 at 09:10

    “Most actively managed funds underperform similarly invested index funds.”

    This is true for most years. But if one looks at the longer term–say a decade–isn’t it true that no actively managed funds outperform similarly invested index funds?

  7. Ely says 13 November 2014 at 09:18

    I have most of my money in index funds, but we do have a small fun-money account invested in individual stocks. We took $1k and bought stuff we liked – Starbucks, Marvel, some green energy companies – at the bottom of the market in 2008. Starbucks and Marvel of course have done very well: Starbucks was trading for $5 at the time, and Marvel was later bought out by Disney. One of the green energy companies tanked, but the other two are plugging along and one has even started paying dividends.

    We didn’t take much risk with this account, but if we had it would have paid off.

  8. Beard Better says 13 November 2014 at 11:12

    The issue with the previous article is not what it was painted as in this article; it’s bordering on outright deception to say that people were annoyed simply because it suggested buying individual stocks. I was particularly annoyed because it was suggested as a plan for people who were already behind on retirement savings, which are exactly the same people who should have the lowest risk tolerance. That article also did not suggest putting only 5-10% of one’s portfolio into individual stocks since, as was said in this article, most pro-indexing people think that amount is fine.

    There is a balance to be found, but it is not anywhere near the middle for the typical investor. Personally, the amount of money I would need to have to start playing around with stock picking is so large that at that point getting more than inflation-matching returns on my investments would be inconsequential.

    • Marsha says 13 November 2014 at 12:25

      I was one of those annoyed by Cowie’s post, and it wasn’t because I think index funds are the only way to go. Our portfolio also contains individual stocks and actively-managed mutual funds. But guess what? We’re NOT behind on investing for retirement, with 8x our annual income in retirement accounts in our early 50’s. And we never let our individual holdings comprise more than 10% of the portfolio.

      I like Brokamp and find his posts sensible and informative, but I’m disappointed that he’s acting as an apologist for Cowie.

  9. Funds says 27 November 2014 at 23:03

    People jumped all over Cowie, largely given that this site is bias towards index funds. I would choose index funds over mutual funds. But Brokamp is wise to point out that those who are working with small amounts of capital and truly do know what they are doing (or are not risk averse and don’t care if they know what they are doing) can be apart of the 20% or so who beats the market. The way I see it you have a 100% chance of matching the market with ETF index funds or a 10-20% chance of beating the market and an 80+% chance of losing to it. It’s a choice for you to make that should largely depend on your financial position and investing knowledge.

  10. Grace @ Investment Total says 09 December 2014 at 01:58

    Thank you for this great insight about stock investing. I sometimes looking for an index if it is going up or going down, If i found an index will get affected by other “risks” (eg global risks, disasters, politics) I pull out my stocks investments and put in the safer investments such as short-term bonds.

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