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Beat the Street

Adam M. Grossman  |  May 12, 2019

WHEN WE ROLLED over into May, I was reminded of a saying I used to hear when I worked in the world of stock-picking: “Sell in May and go away.” The idea—based on questionable data—was that stocks lagged during the summer months.

This notion always seemed suspect to me. But even if it were true, I was never quite sure what to do with it. Should an investor sell everything on May 1 and then buy back on Labor Day? If so, what about taxes? And what about October, when several notable crashes have occurred, including 1929 and 1987? Should an investor really sit out from May all the way to October every year?

Of course, the whole thing seemed ridiculous. But professional investors talk about such things. There are literally dozens of similar pithy sayings that are what comedian Stephen Colbert might call “truthy.” That is, they sound like they ought to be true, but they’re backed up by scant data. That’s one reason, I believe, actively managed mutual funds have lagged behind index funds for so many years. Professional investors rely as much on opinions, gut instinct and pithy sayings as they do on facts and data.

Does that also mean you should never buy an individual stock? Almost universally, I recommend against it. Investors are much better served, in my opinion, buying low-cost index funds, rather than spending time trying to pick stocks. That said, I do believe individual investors have several inherent advantages over professionals. Among them:

1. Long-term focus. Fund managers are subject to constant scrutiny. They don’t have the luxury to endure extended periods of underperformance. For a fund manager, when a stock is lagging, the path of least resistance is simply to sell and move on, even if that stock may ultimately bounce back. But as an individual investor, you aren’t subject to the same scrutiny. You can use patience to your advantage in ways the pros cannot.

2. Flexibility. If you’re running a mutual fund, you need dozens or even hundreds of stocks to build a sufficiently diversified portfolio. That’s a problem because there simply aren’t that many great stocks. The reality is, most of the stock market’s results are driven by just a small number of outstanding stocks. Counterintuitively, this means the majority of stocks end up being below average.

But if you’re running a mutual fund, you can’t just pick a small number of favorite stocks. To manage risk, a fund manager needs a broad portfolio. This can water down performance.

As an individual investor, you aren’t compelled to do this. As long as the core of your portfolio consists of index funds, you’re sufficiently diversified. That will allow you to buy as few individual stocks as you want, limiting your purchases to only your best ideas.

3. On the ground. Whatever your profession, you have areas of expertise that can’t be matched by a fund manager sitting in an office. That’s a huge advantage. You can potentially spot new innovations before they become more widely known.

4. Unconstrained. Virtually every mutual fund has a stated mandate—international stocks or technology stocks, for example—and fund managers must stay in their lane. If they’re running a health care fund, for example, they can try to sneak in other kinds of stocks. But if they do, they expose themselves to the risk of underperformance—and also the risk they’ll be criticized by the fund’s board of directors, the firm’s chief investment officer and fund shareholders.

As an individual, you don’t face these same constraints. You can buy anything. That freedom gives you a much wider pool of stocks to choose from.

5. Zero cost. Perhaps the biggest advantage you have is cost. It’s not unusual for fund managers to be paid $1 million or more, as well as having a healthy budget for research and support staff. Who pays for all that? The fund’s shareholders. That’s a big part of why index funds are so much cheaper; they don’t need to pay all those big salaries.

Consider 2018. The S&P 500 was down 4.4%, but the average large-cap fund fell 6%. How much of that gap can be attributed to costs? This is an easy question to answer. Since the average large-cap fund charges about 1%, costs account for more than half of funds’ underperformance. As an individual investor, you don’t have to incur those same costs.

All that said, stock-picking isn’t easy. As an individual investor, I think you do have a leg up on the pros, but I would still be very careful. I would limit stock picks to a small part of your portfolio—5% or 10% at most. The rest should remain in broadly diversified index funds.

Also, I would take it slow. Think about it more like fishing than hunting. Don’t waste your time digging for opportunities. Instead, put your line in the water and just wait. If something happens to come along, great. But if nothing ever does, you haven’t lost anything.

What kinds of stocks should you be looking for? The beauty of being an individual investor is that there are no rules. It depends on your interests and areas of expertise. Personally, I think the best opportunities appear when great companies hit some kind of pothole.

Consider Lululemon, the dominant maker of yoga gear. In 2013, it endured an expensive and embarrassing recall when a batch of its pants were found to be too sheer—that is, see-through. Then, to make matters worse, the company’s founder tried to blame the customer. Shares promptly dropped from $80 to $40. But today, with that turmoil long past, the stock is up near $180, having dramatically outpaced the overall market.

As a general rule, I find stock-picking to be a pointless activity. Professional stock-pickers often look like a chihuahua chasing its tail, full of activity but ultimately going nowhere. But as an individual investor, it’s worthwhile to understand the ways in which you might not be chasing your tail—should you choose to pick a stock or two.

Adam M. Grossman’s previous articles include After the WindfallOut of Bounds and Not So Easy. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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