As a faithful University of Chicago grad, I’ve long been a believer that markets are generally efficient (for large cap stocks in the U.S, at least). As such, I’m always skeptical of advisors that peddle their ability to select individual stocks that they claim will beat the market over the long term. Lackluster performance from active mutual fund managers—who have immense resources at their disposal to research and amass data on individual stocks—prove that individual stock-picking is very, very difficult to do on a consistent basis; the vast majority of U.S. stock fund managers fail to beat their benchmark over the long term. For the very few that are able to do so, the chances of an investor sticking with that manager for long enough to realize those outsized returns are even lower. Warren Buffet—one of the greatest stock-pickers of all times whose long-term track record is more than double the S&P 500—has underperformed the index for more than 10 years and counting (and is also one of the most vocal advocates for index funds). The S&P 500 is an unmanaged index of 500 widely-held stocks that is generally considered representative of the U.S. stock market.
Undoubtedly, there are still many places in the world where markets are not truly efficient and an informational advantage can still be had by skilled stock-pickers. International small and mid-cap markets is one prime example (though their prices can be more volatile). That’s why at Center for Financial Planning, we use a combination of active and passive funds to build portfolios. In markets that are highly efficient, like the U.S. large cap space, the core of our holdings are low-cost index funds that provide broad market exposure. Where we do use active funds in efficient markets, it is typically with the aim to manage risk rather than achieve return outperformance. In areas where the data tell us there is still the potential for an informational advantage, we rely more heavily on active managers.
Given all that I’ve said above, why on earth would I recommend buying individual stocks of large U.S. names? Well, turns out there are other compelling non-investment reasons to own them, particularly in taxable accounts. There are still many cases where we recommend clients own individual stocks, as well as a core of index funds (index funds or ETFs are typically used since individuals cannot invest directly in any index), in efficient markets: for instance, holding enough individual stocks to closely track the benchmark, often with a growth or income tilt that is appropriate for the client’s individual circumstances. In all these cases, our goal is not outperformance of an index, but rather achieving index-like returns with other added benefits.
The three main reasons to own individual stocks in an efficient market are:
1. Individual stocks allow for greater potential to maximize tax efficiencies of gifting appreciated securities in up markets.
2019 was a banner year for U.S stocks. The S&P 500 index racked up gains of over 30% for the year. As you can imagine in an index of 500 names (actually 505, to be specific), not all companies experienced the same average return. Within the retail industry alone, the performance differential was stark: one leading retailer that was up over 90%, while another more traditional department store was down nearly 45% (and also subsequently lost its spot in the index this year to add insult to injury). Investors lucky enough to hold such winners may see their positions grow to an overweighting no longer appropriate for their portfolios, but disposing of these winners can also mean a large tax bill.
Charitably-inclined investors may want to reduce this tax bite by gifting appreciated securities. Rather than writing a check to their charity of choice, sending securities with long-term embedded gains instead can result in meaningful tax savings (and potentially more funds available to donate!). Furthermore, gifting appreciated securities to a Donor Advised Fund can also result in a very powerful combination of frontloading tax deductions of the gift (thus offsetting income in higher earning years) and also removing low basis securities from a portfolio (thus reducing gains recognized when those securities are later sold). (As always, donors should consult a tax advisor with respect to questions relating to the deductibility of various types of contributions to a Donor-Advised Fund for federal and state tax purposes.)
Tax-wise, gifting shares of an index fund that appreciated 30% is great (thus avoiding the 20% long-term capital gains rate, 3.8% Medicare surtax, and any additional state tax for top earners), but arguably not as great as gifting shares of a stock that appreciated two or three times that amount. The individual stock could then be repurchased (at a higher basis) to maintain the desired exposure in the portfolio.
2. Individual stocks allow for greater potential to tax loss harvest in down markets.
The rosy uptrend of 2019 witnessed a sharp reversal in late February 2020 as the arrival of the coronavirus shook U.S. markets; the S&P 500 registered a 20% decline for the first quarter. If an index fund holding in a taxable account happened to be at a loss, some investors may have chosen to sell it during this time and recognize this loss on their tax return. This concept is called tax loss harvesting, which refers to the practice of selling investments at a loss to reduce tax liability. However, since wash sale rules prevent investors from rebuying a substantially identical investment within 30 days before or after the sale, there would be a limited to what an investor could repurchase to ensure they maintained the broad-market exposure similar to what they sold during the 30-day window. For instance, investors who sold a position selling at a loss at the end of March and remained in cash, could have potentially missed the incredible rebound that occurred during the month of April.
Conversely, owning individual stocks instead may have given an investor more flexibility to selectively tax loss harvest. First, individual stocks offer a much wider variance of returns than an index (consider one healthcare company’s 30% rise during first quarter compared to an ill-fated cruise line’s 80% decline). Second, individual stocks can offer more flexibility to achieve an investor’s desired exposure during the 30-day wash sale window (allowing the potential to sell that cruise line that may have been held and buy a rival for 30 days or even perhaps a travel and leisure index fund, for example, should the investor have had the intestinal fortitude to do so). Assuming the same dollar amounts of the sale, the potential tax liability reduction from selling the 80% individual stock decliner would likely be much larger than the 20% decline of the index.
3. Individual stocks can be just plain interesting!
After reading my argument against individual stock-picking with the goal of beating the market, readers may be surprised to find out that I was a stock analyst for much of my professional career. After several years of researching and providing recommendations on individual stocks firsthand, I know how hard it is – but I also know how interesting it can be, too. My favorite part of my job as an analyst was learning the companies’ stories. I loved learning about their histories and products. I loved evaluating their competitive position. I loved visiting their locations and seeing their operations with my own eyes.
Sure, conceptually I know that I own stocks indirectly through my index fund, but for myself and many others, it is simply more exciting to own the stocks themselves. It’s fun to be able to see the same names on an account statement that I frequent at the mall, and I always feel a little better about an online retailer hiking its membership fee because I am getting a (albeit, infinitesimal) part of it back as a shareholder. Heck, it even feels patriotic owning a share of American business, American ingenuity.
For some, owning a sufficient number of individual stocks to achieve sufficient diversification (with the goal of achieving index-like returns) makes a lot of sense and provides positive utility to the investor compared to just owning an index fund. Depending on a given investor’s individual circumstances and resources, a small portion of the portfolio could even be reserved for “hobby” investing that diverges from this index-tracking goal. Here’s where an investor might allocate their desire to try to pick the biotech that will potentially develop the coronavirus vaccine or the next tech startup most likely to be acquired. For this to be a viable option, however, the investor must fully understand the downside risk and also have sufficient funds available elsewhere to meet their goals. Every investor's situation is unique, and investment goals, risk tolerance, and time horizon should be considered before making any investment.
To conclude, advisors touting hot stocks that they claim can beat the market are simply ignoring the data while dismissing individual stock investing as a whole can cause investors to miss out on other important benefits. In my opinion, wealth management is the true marriage of investment management and financial planning concepts such as these.
Lauren Adams, CFA®, CFP®, joined Center for Financial Planning (www.CenterFinPlan.com) in 2016. Previously, while at Morningstar, she worked as a Senior Equity Analyst, Director of Cross-Sector Equity Research, and Product Manager.
Any opinions are those of Lauren Adams, CFA®, CFP® and not necessarily those of Raymond James.
Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC. Investment advisory services are offered through Center for Financial Planning, Inc.® Center for Financial Planning, Inc.® is not a registered broker/dealer and is independent of Raymond James Financial Services.
Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investments and strategies mentioned may not be suitable for all investors. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Individual investor's results will vary. Past performance does not guarantee future results.
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As a faithful University of Chicago grad, I’ve long been a believer that markets are generally efficient (for large cap stocks in the U.S, at least). As such, I’m always skeptical of advisors that peddle their ability to select individual stocks that they claim will beat the market over the long term. Lackluster performance from active mutual fund managers—who have immense resources at their disposal to research and amass data on individual stocks—prove that individual stock-picking is very, very difficult to do on a consistent basis; the vast majority of U.S. stock fund managers fail to beat their benchmark over the long term. For the very few that are able to do so, the chances of an investor sticking with that manager for long enough to realize those outsized returns are even lower. Warren Buffet—one of the greatest stock-pickers of all times whose long-term track record is more than double the S&P 500—has underperformed the index for more than 10 years and counting (and is also one of the most vocal advocates for index funds). The S&P 500 is an unmanaged index of 500 widely-held stocks that is generally considered representative of the U.S. stock market.
