In response to a comment on the Canadian Dream blog, Preet of Where Does All My Money Go asked this question:
Why would you ever buy individual stocks to add to your portfolio of indexed products? If I’m not mistaken you do add the odd position or two, do you not? Is that not an “active” strategy?
If I do recall correctly, and you DO purchase individual positions, would you agree? If not, I would be curious as to the rationale…
If you’ve followed this blog for a while you know that I’m a big fan of indexing and I have mostly given up on picking stocks for the majority of our portfolios. However, I still plan to capture Canadian exposure through individual stock positions. So, it’s fair to ask why and I’ll try to explain.
There are two reasons for picking individual stocks: (1) Canadian stocks held in our taxable accounts receive favourable tax treatment in the form of the dividend tax credit. I like to buy stocks with a long history of growing dividends at a reasonable price. With individual stock picks, I can easily double the yield on a Canadian stock portfolio than the underlying index. (2) I love to pick stocks. I find it intellectually challenging to research stocks and find it hard, but satisfying, to patiently wait for buying opportunities and, to be honest, a bit tiresome to read earnings reports to keep track of my holdings.
You’ll notice that, financially speaking, (1) is a reasonable argument but (2) is not. I am under no illusion that I am going to beat the pants off the index. In fact, I recognize that the odds are against outperforming the index. However, I am confident that we will easily meet our financial goals even if I am terrible at picking stocks, so I am okay with my choice. I do increase my chances of being successful by reducing turnover and avoiding “story” stocks. Still, you are welcome to characterize my fling with active investing as yet another triumph of hope over experience. If the experiment turns out badly, the damage will be limited to a portion of our portfolios.
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15 responses so far ↓
1 FourPillars // Dec 20, 2007 at 10:10 am
I’m the same way.
I don’t think you have to be 100% “indexer” or all “stock picker”. I have a combination of stocks, mutual funds and etfs.
2 Canadian Capitalist // Dec 20, 2007 at 10:24 am
Mike: I just wanted to point out that picking stocks doesn’t necessarily mean that I believe you can beat the index. I track my performance against benchmark and the record is that I’m barely keeping pace with the index even after taking into account “free lunches” like ESPP profits and ignoring taxes. Even if I did manage to beat the index handily so far, it will be hard to tell if it is due to skill rather than luck.
It’s true that initial mistakes with tech stocks hurt performance but unlike executives who can exclude “one-time items” from earnings reports, investors have to count their mistakes in tallying up numbers.
3 Plan Your Escape // Dec 20, 2007 at 10:47 am
I like your second reason. I find it more “fun” to pick stocks. I know I’m not likely improving my returns but it keeps things interesting. I don’t want to get bored and lose my motivation. So I let myself pick some stocks. I generally go for proven dividend payers but I’ve got small speculative position as well. It keeps things interesting without keeping me up at night when the market is all over the place like it is these days.
Peter
4 WhereDoesAllMyMoneyGo.com // Dec 20, 2007 at 11:50 am
Great post CC!
I still think you are underestimating your abilities as you are clearly one smart cookie.
Thanks,
Preet
5 Canadian Capitalist // Dec 20, 2007 at 11:59 am
Preet: Honestly, I’m not trying to be modest. I’m simply stating facts and I’ve been publishing my track record from the beginning. I encourage everyone to track their performance and see for themselves how they are performing vis-a-vis a “lazy” portfolio. If they are beating it, they should ask themselves if it’s luck or skill. If not, maybe their financial goals will be better served by a “lazy” portfolio.
6 Michael James // Dec 20, 2007 at 12:00 pm
I too am a big fan of indexing, but I like to pick some stocks as well.
You said that in your stock picking “the odds are against outperforming the index.” If the index represents the market as a whole, and you keep trading to a minimum, and we treat your stock picks as random, wouldn’t the odds of doing better than the index be roughly even money? Maybe you meant that the odds of significantly outperforming the index are low, which I agree with.
I hold out the hope that I’m actually a slightly better stock picker than average, but I don’t put enough time into it to justify building my entire portfolio with my small number of picks. So, I just have a fraction of my money in my own picks.
Michael James
7 moneygardener // Dec 20, 2007 at 12:26 pm
CC, I think that is a great response to that question.
8 Canadian Capitalist // Dec 20, 2007 at 3:02 pm
Michael: Assuming we are talking about a broad-based capitalization-weighted index, it’s tough to say what the odds are than one stock will outperform the index because it will be all over the map. If a handful of large caps posted great gains, the odds are small that a random stock will outperform the index. On the other hand, if large caps are suffering and small caps performing well, the odds are better than even that a random stock will outperform. In a given year, who knows which scenario will play out and to what degree?
9 moneygardener // Dec 20, 2007 at 4:05 pm
It is much easier to be a semi successful stock picker if you stick to some simple rules:
1. Only invest in companies that raise their dividend every year.
2. Only invest in companies with a long history of consistent EPS growth
3. Only invest in comapnies with Return on Equity over 15%
10 Michael James // Dec 20, 2007 at 4:09 pm
CC, I completely agree with you about the uncertainty with the outcome on any one stock in a given year. Over the course of many years and many picks, I think it is likely that my performance will not differ much from that of the index in the same way that random picks should not differ much from the index over the long term.
If it turns out that I have any talent at stock picking, it will only show after many years of data gives statistically significant results.
11 Canadian Capitalist // Dec 20, 2007 at 6:25 pm
Michael: There is some evidence for your comment. I thumbed through Four Pillars of Investing and Bernstein cites a study (Page 100 if you have the book). The study looked at 1000 random portfolios of 15, 30 and 60 stocks and found that the 50th percentile achieved the market return in all instances. So, it appears that you do have an even chance of beating the market with a random portfolio.
12 laketrout // Dec 20, 2007 at 6:35 pm
I plan to follow a very similar plan.
My employer has a savings plan that where I can deposit up to 10% of my in a money market fund and they’ll match 3%. With four free withdrawals a year I plan to make four ETF index purchases a year inside my RRSP. Then, using Preet’s idea of using your tax return in an efficient manner, I plan to use my tax return to purchase individual Canadian dividend paying stocks to be held outside my RRSP.
13 laketrout // Dec 20, 2007 at 6:38 pm
BTW… You’ll have to excuse me. I have a mild case of the flu and can’t type very coherently.
14 Dave // Dec 20, 2007 at 9:05 pm
If your trading costs are less than an index ETFs per year, you have greater than 50% odds of beating an index.
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