I RECENTLY READ an interesting article about why you shouldn’t pick individual stocks. The author mentioned the classic reason: “Since most people (even the professionals) can’t beat the index, you shouldn’t bother trying.”
He also mentioned another reason: “The existential dilemma of doing so… how do you know if you are good at picking individual stocks?” The author goes on to mention that, since luck plays such a significant factor in stock-picking, it could take a very long time to determine if you’re good or just lucky and, even then, you may never really know.
While these are both good reasons not to invest in individual stocks, it strikes me there are other reasons—nine of them, to be precise.
1. I’ve always been concerned that, when stock-pickers compare their results with an index, they may not know which index to use. I own a unique mix of master limited partnerships, individual stocks and mutual funds. I compare my results to the S&P 500. But since my portfolio is a little more value-oriented, maybe I should use the Russell 1000 Value Index. But I also own some foreign stocks, so maybe…. My concern about selecting the correct comparison index always seems to increase in years where I underperform the S&P 500.
2. Stock-pickers have to deal with buyouts and reorganizations, which then trigger capital gains. This plays havoc with tax planning and possibly with income planning. A few years back, a very significant position of mine, Kinder Morgan Partners, was reorganized from a master limited partnership to a corporation, sticking me with hefty unplanned capital gains. It didn’t help when the company subsequently cut its dividend, which led to a precipitous decrease in its stock price. Who likes to pay tax on capital gains, only to see the value of your current position is worth less than the capital gain you’re getting taxed on?
3. Brokerage firms can misclassify a stock’s dividends. The first page of a 1099 sums and classifies all the dividends, distributions, interest and so on. But what if it’s incorrect? I generally review my 1099’s details to see if there are any noticeable issues, but I certainly don’t go through it with a fine tooth comb. This year, I noticed my dividend amount was much higher than last year’s. It turns out that E*Trade incorrectly classified a tax-free spinoff of shares of Brookfield Renewable Partners as taxable. I’ve been “discussing” this with them for more than a month. Wish me luck.
4. Reporting each individual stock’s capital gains after a sale, buyout, special dividend and so on can be time consuming. Tax software may help with this issue, but you still need to verify the numbers (see No. 3). Also, prior spinoffs, returns of capital and multiple purchases can make determining the cost basis quite complicated. In 2011, brokerage firms started reporting cost basis, which is helpful. But if your stock has had multiple spinoffs or mergers, checking your brokerage firm’s math can be difficult.
5. A stock-picker who invests in foreign stocks will have to pay foreign taxes. He may then think, “Well, I’ll just claim a foreign-tax credit and everything will be jake.” Well, it may be—or may not.
6. If you own individual stocks, you can look forward to an avalanche of proxies. Each company states that “your vote is important” and offers the stock-picker the illusion of having a say in how “your” company is run. In reality, the amount of “your” say is vastly overstated, plus “your” company generally doesn’t have to abide by the results of “your” votes. Directors are reelected with less than a majority, and advisory votes on compensation are ignored. While your vote in public elections always counts, in corporate “elections” it’s much less so.
By sticking with mutual funds, you can avoid the hassle, the waste of time and the guilt. I take my shareholder responsibilities more lightly with every passing year and, now that I’m retired, I can’t be bothered, though I always vote for independent chairpersons. Note: I voted against ExxonMobil management in this year’s proxy fight, which culminates with today’s annual meeting. As my mother used to say, “Hope springs eternal.”
7. If you own individual stocks and have beaten the index (see No. 1), you may now believe yourself to be an above-average investor. This may tempt you to use your individual stocks to write options. If you haven’t done so well, you may still be tempted. Mutual fund owners do not have this temptation.
For example, you underperform the index for a few years and think you can make up some of this shortfall by writing call options on your shares of, say, Walt Disney Co. But then Disney has an unexpectedly good quarter and your shares get called away, leading to unforeseen capital gains (see No. 2). You also then miss out on the subsequent share price increase. Then COVID-19 hits and Disney shares drop significantly, and you start feeling pretty good about your investing acumen—for a little while. Then Disney subsequently comes roaring back and then some, without you on board. Note: This is all hypothetical.
8. Some stock-pickers try to use their picks to generate a certain amount of income, an amount they feel they “need” from their portfolio. These folks tend to hew toward higher-yielding stocks. Common sense, corporate finance and tax regulations all argue that yield shouldn’t be a factor in selecting stocks. By focusing on yield, stock-pickers unnecessarily limit the stocks they might own, which can’t be a good thing. What if you need more income from your investments? Taking some capital gains, by selling a small portion of your portfolio, is the best way to accomplish this. It will also allow you to better time your capital gains to assist with tax planning (see No. 2).
9. Unless a stock-picker has the stomach of a jet pilot and the discipline of a Spartan warrior, buying individual stocks on a regular basis is almost impossible. When the stock market is setting record highs, you won’t invest, as you’ll think, “How can the market get any higher?” When the market is setting new lows, you won’t invest, as you’ll think, “What if things get really ugly?” Setting up automatic investment plans, where you invest regularly in low-cost mutual funds, will allow you to bypass such questions and the associated stress, while providing the added benefit of dollar-cost averaging.
By now, you may be thinking, “Okay, we get it, enough already. It sounds like you’re trying to convince yourself.” And you would be correct. The observant reader will have noticed I still own some individual stocks and ask, “Why don’t I take my own advice?” I’m trying. I’ve reduced my holdings in individual stocks. But in the words of the long-term smoker who’s trying to quit, “It’s tougher than you think.”
Michael Flack blogs at AfterActionReport.info. He’s a former naval officer and 20-year veteran of the oil and gas industry. Now retired, Mike enjoys traveling, blogging and spreadsheets. Check out his earlier articles.