Russell_3000_1995-2014

I recently read an article on etf.com by Larry Swedroe, who is the Director of research for the BAM Alliance, on the subject of stock selection by individual investors. The title of the article is “Why Buy Individual Stocks?” He comes at the subject from two directions. The first, from a purely statistical direction, cites a study (readily available on the internet) that analyzes the contribution of individual stocks to the performance of the Russell 3000 index. The second direction is that of human behavior as it applies to investing and more specifically, to stock selection.

For the statistical aspect, he relies on a study titled The Capitalism Distribution, which analyzes the Russell 3000 index over the period of 1983 to 2006. The Russell 3000 is comprised of the 3000 largest US stocks by capitalization and includes roughly 98% of the US stock market. Given the dynamic nature of the market, the universe under study over the time period was 8000 stocks “…that would have qualified for membership in the Russell 3000 at some point in their lifetime.” The study is compact, well-presented and worth taking time to read and absorb. Most significant from my view is the sheer number of stocks that any investor must choose from coupled with the fact that 75% (6000) of the stocks had a collective return of 0%. The best performing 25% (2000) of the stocks accounted for all the gains in the index. This also is a pretty large number. No individual investor has the time or resources to effectively analyze such large number of stocks, much less pick the winners. From a numbers point of view, the deck is really stacked against you.

Swedroe’s second and probably more important point is that individuals are just bad at picking stocks. There are a number of potential reasons that he enumerates based on studies and research. The first among these is lack of financial education. Individual investors haven’t studied financial theory and generally don’t read financial journals. The lack of financial understanding is compounded by normal human behavioral traits that in essence make investors believe that they are more competent than they truly are.

Swedroe’s conclusion is that  investors that try to pick individual stocks will fall short of the index performance. Index funds are the most effective investment choice.  As a retiree, your really have very little means of recovering from poor choices. You cannot afford to fool yourself and try to maintain your retirement assets by picking individual stocks.