Three Reasons to Own Individual Stocks in an Efficient Market
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.