Written by: Corey Janoff
This post was originally published on our previous blog website on February 14, 2017 and has since not been revised and/or updated.
This week’s post comes to us from Lukas Ng, AIF® of our Seattle, WA office.
Last year I sat down with an old classmate of mine from college to reminisce about the good old days where we spent countless nights eating Domino’s Pizza trying to prove theorems for class. We also talked about our interests these days, from our favorite recipes and experimentations with food to our favorite restaurants and food destinations. I know… very diverse interests. Eventually we started talking about work and when I brought up what I do for living as a financial advisor and how mutual funds work, his response was, “Why would I ever use a mutual fund? I get the diversification aspect of it, but if I had a million dollars I’d much rather put together a stock portfolio with companies that I believe in and monitor myself. I bet I could do a better job than a mutual fund manager once you account for the costs.”
I didn’t want to put a damper on the mood so I didn’t address the point any further that evening, but when it comes down to it there are a few different types of investors that may try to pick individual securities:
1. Uneducated Retail Investors
This group has some or no knowledge on the world of finances. Picking stocks is akin to blindfolding themselves and throwing a dart at a board. They could get lucky and strike gold, but could also get just as unlucky and end up picking an investment that does not pan out.
2. Educated Individuals, Financial Advisors, Wealth Managers
This group has some or maybe a lot of knowledge on the economy and the stock market. More knowledgeable than the first category but without the resources of a manager at a fund. That said, a miscalculation, company scandal, or random geopolitical shift could render decisions on individual securities from this class of investor no more viable than the first class of investor.
3. Mutual Fund & Hedge Fund Managers
This group has a lot of knowledge on the economy and the stock market with an arsenal of resources at their disposal and analysts that help guide their decisions – tools and access to information that the previous two groups lack. This class of investor likely has an enormous amount of experience in the industry with credentials to back it up (such as a CFA or Ph.D) as well as a team of people feeding them information. Unexpected events can still influence the markets in an unexpected way they do not foresee.
An underlying theme for these categories of investors is an unexpected event can occur at any time causing individual securities or markets in general to behave in an unexpected way. However, there is no comparison to the amount of time and resources the third class of investor dedicates towards portfolio management. The managers of these funds literally sit around all day long doing nothing but keeping up-to-date with the news, synthesizing information from the analysts they have at their disposal, and making decisions on the securities they have in their portfolio. The other two categories of investors do not have the same amount of time to dedicate towards making decisions on securities, let alone do they have the same resources. As a result, over a long period of time it may make sense to utilize fund managers to do the heavy lifting for you, and merely make sure you choose managers you trust in different sectors of the economy to make sure you’re diversified.
The Overconfidence Syndrome
According to numerous different studies, there is a human bias towards overconfidence and thinking we are better at doing things than we actually are1,2. For instance, 94% of college professors think they do above average work which is nearly impossible from a statistical standpoint1. This same overconfidence effect often applies directly to investing, where individual investors think they have an upper hand or have some secret skill/technique/algorithm that no one else in the world has ever thought of or used. The almost certainly, as it turns out, is not the case. If there was some way, you and I would be retired on a tropical island somewhere with a helicopter in our backyard.
With all this in mind, I’m not saying you should never invest in individual stocks if you like or believe in a company. At the end of the day, what you do with your money is your decision. It may merely be a more prudent move to diversify & invest your assets for retirement and square away all other the aspects of your financial plan first, before moving on and playing with investing in individual companies. The last thing we’d want is to lose a large portion of our retirement savings on a bad bet.
Sources
- Anderson, Cameron. Brion, Sebastien. Moore, Don. Kennedy, Jessica. “Why are people overconfident so often? It’s all about social status”. Berkeley Haas – Haas Now, 13 August 2012.
- Sandroni, Alvaro. Squintani, Francesco. “A Survey of Overconfidence, Insurance and Self-Assessment Training Programs”. University of Warwick. August 2004.
Disclosures:
These are the opinions of Lukas Ng and not necessarily those of Finity Group or Cambridge Investment Research, Inc., are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Investors should carefully consider the investment objectives, risks, fees, and expenses before investing. For this and other important information, please obtain the investment company fund prospectus and disclosure documents from your Advisor. Read this information carefully before investing.
