Should You Attempt To Pick Individual Stocks?
Not everyone should attempt to pick individual winning stocks in the market.
Only if you can satisfy the following conditions should you attempt to pick individual
stocks.
1. You must believe that it is possible to beat the market by picking
individual stocks.
2. You must have some method in mind as to how you will pick stocks and beat
the market.
3. You must have the time and inclination to apply the method.
If you do not believe that it is possible for anyone to consistently beat the
market by picking individual stocks (particularly after trading fees) then you
should invest the equity portion of your portfolio in the broadest possible
equity index funds. This is a perfectly reasonable position to take and many
market observers believe that this is the best approach. Note that most advisors
and equity market brokers will argue against this since it effectively cuts them
out of a job.
If you believe that it is possible to beat the market but you yourself don't
know how to do it or don't have the time or interest to attempt it then it is logical
to use an advisor or and/or mutual fund approach. You should look for an advisor
or a mutual fund manager(s) that has an excellent track record and that you feel
comfortable with.
But if you believe that you are capable of beating the market on your own,
then you should articulate the approach that you will use.
I can think of several broad approaches that people use to attempt to beat
the market
1. Charting Approaches. (Another name for this is technical analysis.)
Essentially these methods try to predict where the crowd is going. They ask the
question "which stocks will go up". Investors attempt to read signals from charts in a sophisticated
manner. These methods can be very complicated. Academics tend to dismiss most of
this out-of-hand. However, it is followed by many investors.
A sub-set of the charting approach is the momentum approach. Buy hot stocks and then sell them when they turn down
in price. Academics have observed that there is some momentum in the markets and
this method has worked well for many investors. The challenges include how to recognize
when the primary trend of a stock has really changed from up to down, since
stocks don't rise or fall in straight lines.
All charting approach investors have to be
disciplined to sell losing positions quickly and cut their losses when a stock
fails to rise as expected.
3. Buy Growth Stocks. Buy stocks that have achieved very high sales
(and ideally income) growth rates. Buy them even when their valuations seem very
high, since the theory is that the sales and profit growth will eventually
justify the price paid.
4. Buy Value Stocks. This method asks the question, "which stocks should
go up?". Value investors look at the fundamentals of the company including
sales, earnings, book value, growth, risk and overall outlook. The value
investor uses present value techniques to calculate an estimate of the true
value of a stock and then buys those stocks that are trading below their true
fundamental values. Short-cut value methods include simply buying low P/E or low
price to book value shares, but more skilled value investors consider many
factors to calculate an estimate of the stocks true intrinsic value. This method
requires an investor to have faith in his or her own analysis. Value investors
tend to be patient and are willing to ignore the market in the short term based
on a belief that in the long term the market will recognize and fully value each
stock. A common mis-conception is that value investing excludes growth stocks.
In fact value investors recognize the value of growth. They typically seek
growth stocks but will only buy them when they are under-valued in the market.
So, if you can meet all three conditions presented at the start of this
article and if have selected a stock picking methodology that suits your skills
and temperament then, Yes you should attempt to pick your own winners in the
stock market.
Alternatives to picking your own stocks include following advice of a trusted
newsletter or publication that picks stocks, turning your funds over to a
portfolio manager, relying on a full-service broker, investing only in index
funds or investing in mutual funds.
December 8, 2001