PassionSaving.com

Stock Picking for Indexers

Benefit #1 of Stock Picking for Indexers — It can increase your returns.

John Bogle’s argument for indexing is that half of all investors must obtain a return worse than the market return. Transaction costs are less for indexers. So, after consideration of transaction costs, indexers must do better than stock pickers on an overall basis.

Stock Picking for Indexers

It doesn’t follow that those who see appeal in the idea of investing in a broad index shouldn’t also see appeal in the idea of aiming for the higher returns possible through stock picking. You have to watch expenses, of course. Those who are careful not to trade often can overcome that hurdle. You need to be sure that you possess better-than-average stock-picking skills. Most investors seeking financial freedom early in life are in that category. And you need to provide for enough diversification in your portfolio so that a number of bad picks will not ruin you.

There are lots of people who invest in ill-informed ways. Each investor who invests in an ill-informed way opens up an opportunity for those of us who aim to invest in an informed way. Investors who put their money in hot tips or story stocks earn lower-than-market returns. If it is possible by being dumb to earn lower returns, it must also be possible by being smart to earn higher returns.

There’s no good reason why indexers should not tap into the rewards of stock picking.

Benefit #2 of Stock Picking for Indexers — Stock-picking strategies complement indexing strategies.

Indexing is a safe approach to investing. You cut out the best possibilities and you cut out the worst possibilities and you assure yourself of obtaining the “good enough” market return.

Stock picking is both more exciting and more dangerous. Choose well, and you can make money faster with stock picking than you can with indexing. Choose poorly, and you can get wrecked.

It sounds like these two approaches should be mixed, does it not? The best marriages are those between The Practical One and The Dreamer. We all know people who took too many risks and died young. We all also know people who took too few risks and died too young in a different way. The sensible middle path is to take on some risk and to counter it with some safe moves.

Indexers who engage in stock picking win for themselves the best of both worlds. Indexing provides a strong measure of diversification for a portion of their portfolios. Stock picking provides some added tiger in the tank to the extent desired.

There is no requirement that indexers engage in stock picking or that stock pickers engage in indexing. I don’t understand, though, why indexers often come across as being hostile to stock pickers and why stock pickers often come across as being hostile to indexers. It’s not an either-or, is it?

Stock picking possesses an obvious appeal. Indexing possesses an obvious appeal. Is there any reason why we should not feel free to mix the two approaches to come up with portfolios that best serve the purpose of advancing investors with our own particular financial circumstances and pursuing our own particular Life Goals? I am not aware of one.

Benefit #3 of Stock Picking for Indexers — It makes it more likely that you will stick with your strategy.

Stock pickers do well when one or more of their picks does well. Stock pickers do poorly when one or more of their picks do poorly. Indexers do well when the market does well. Indexers do poorly when the market does poorly.

Get Rich of Die Trying

Stock pickers are tempted to abandon their strategy when they experience a long run of poor returns. So are indexers.

Those who engage in a combination of indexing and stock picking are less likely to experience a long run of poor returns. When their stock picks are doing poorly, the market may be doing well. When the market is doing poorly, their stock picks may be doing well.

A portfolio that contains both individual stocks and shares in an index benefits from a diversification of strategies. The stocks held by the owner of this portfolio are not as well diversified as the stocks held by a pure indexer. In a larger sense, however, this portfolio may achieve greater diversification as the investor’s fortunes are not tied to the success of a single investing strategy.

Benefit #4 of Stock Picking for Indexers — It helps you avoid dogmatism.

Dogmatism is the long-term investor’s worst enemy. We all fear putting our money at risk. None of us possesses perfect information as to how our investments are going to perform. So we all seek assurances that we have made good investing decisions.

Often it is that quest for reassurance that ruins us.

The fearful investor’s quest for reassurance often leads to dogmatism, a rigid refusal to acknowledge the weaknesses of his own choices or the appeal of the alternatives for which he elected to take a pass. I’ve seen investors transformed into boys in the schoolyard taunting each other with cries of “My asset allocation is more rational than yours!”

You can’t have every investing approach represented in your portfolio. That would render it an illogical mishmash. But in cases in which two investing styles work well together and in which it makes sense for someone in your circumstances to combine them, diversification of styles can help head off dogmatism. You can hardly find fault with stock pickers when you are one yourself, can you? You can hardly find fault with indexers when you are one yourself, can you?

Do you remember that great commercial that argued that —

Sometimes you feel like a nut.
And sometimes you don’t!

Here’s my financial freedom lover’s version —

Sometimes you feel like an indexer.
And sometimes you feel like a stock picker!

No, it doesn’t sing. But I bet you will never again hear that commercial without for a moment considering the merits of combining stock picker strategies with indexing strategies!

Benefit #5 of Stock Picking for Indexers — It provides an easy means to begin a transition to a new index.

Indexing purists would have you believe that they have discovered the Holy Grail of investing strategies. No one knew anything about how to invest rationally before Saint Jack arrived on his horse. Then the skies opened and we all got taught the true religion. Now we know, or at least we darn well should. If there is anyone today not indexing with 100 percent of his or her portfolio, names will be recorded and steps will be taken.

They Used Our Natural Risk Aversion Against Us

Please don’t let anyone know that I was the one who happened to mention this to you, but some of the purist indexers are a wee bit touched. Saint Jack is a fine fellow with a fine kettle of ideas. He’s not actually a saint, though. Not yet anyway. That’s just some people talking. Bogle continues to walk the Valley of Tears as of February 2007 (that’s when this article was posted).

Anyway, a lot of people have taken a liking to Jack’s idea of investing in an index. The only trouble is — What index?

Should it be the S&P? Should it be the total stock market? Should it be a fundamental index? Should it be an index with a value tilt? Should it be a global index?

No one knows!

What if we persuade everyone in the world to index but we can’t agree on what that means?

If you are a stock picker, and begin thinking that you need to move into value a bit, you could pick a few value stocks. If you are a stock picker, and begin thinking that you need to move into global a bit, you could pick a few global stocks.

Purist indexers have no flexibility, especially if they buy into a severe vision of buy-and-hold. Stock-picking indexers have the option of trying some things out and then deciding whether to move on to a second date or not.

Benefit #6 of Stock Picking for Indexers — It’s fun.

Even purist indexers acknowledge that indexing is boring. Many indexers “permit” themselves to pick one or two stocks just to keep the blood running through their veins.

Life is short. Live it up! Make stock picking part of your “official” strategy and you no longer will feel that you are “cheating” when you engage in it.

Do you want to know what I think? I think that a whole big bunch of indexers are already mixing stock picking and indexing. They play it down in public because they worry that the purists might toss drinks in their faces if they found them out.

My guess is that there are lots of poor souls who pick one or two stocks thinking that it can’t do all that much harm. Then one day they wake up to realize that they are addicted! Oh, yes, stock picking can be hard to stop, especially if you spend most of your life confined to the drab and gray prison cell of an indexing purist.

There is a house in New Orleans
They call “The Rising Sun.”
It’s been the ruin of many a poor indexing purist.
And, Lord, I know — I’m one.

It’s a sad and disturbing song, but it’s one that they’ve been singing since the day that Saint Jack arrived on his big white stallion. I’m saying: “Let’s legalize stock picking and maybe we will be better able to control it. Maybe people will no longer feel a need to turn to a life of crime to support their stock-picking habit.”

Risk Tolerance in the Real World

It’s a progressive idea. But, hey, that sort of thing is “in” today, no?

Benefit #7 of Stock Picking for Indexers — It allows you to tilt your portfolio in desired directions.

Some investors think that indexing works, but that the broad indexes do not contain enough value stocks. Some investors think that indexing works but that the broad indexes do not contain enough small-cap stocks. Some investors think that indexing works but that the broad indexes do not contain enough high-dividend stocks.

These people do not have to buy value indexes or small-cap indexes or high-dividend indexes to go along with their broad indexes. They can buy individual stocks that possess the traits they are seeking.

Indexes do a lot. There is no rule of the universe that says that indexes need do it all.

Benefit #8 of Stock Picking for Indexers — It helps you learn.

Stock pickers can never forget how it is that stocks generate returns for those who invest in them. Since they are always on the lookout for better stocks, they are learning all the time more and more about what comprises a good stock.

This is not so of indexers. Stock pickers are one step removed from the profit-generation machine (they don’t work for the companies they invest in). Indexers are two steps removed. Indexing is an artificial way to invest. Taken too far, this artificiality can become dangerous.

Indexing works best for those who keep both feet on the ground at all times. Stock picking forces you to keep both feet on the ground. Stock picking helps you avoid the worst pitfalls of the indexing approach.

Don’t turn out like that poor girl whose face you saw looking down at you from the window of that house that isn’t any home. Be an indexer, sure. But be an indexer with both a heart and a brain. Be one of them new fangled stock-picking indexers!

Oh! There’s one more benefit, one for which I didn’t think I should create a separate listing. Knowing that there are indexers out there who engage in stock picking drives the indexing purists positively bonkersville!