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.
- You must believe that it is possible to beat the market by picking individual stocks.
- You must have some method in mind as to how you will pick stocks and beat the market.
- 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