What is stock picking?
Stock picking is personally searching the stock market for suitable companies to invest in, it can be like hunting for a needle in a haystack, even for those using software programs and trading algorithms.
The Pitfalls of Stock Picking
You may have done some research on a specific company and, at least on paper, it seems to stack up. It could be a large, well-known company, whose share price has risen over time. It also has a record of paying out dividends.
Or maybe you have your eyes on a smaller company that you’ve heard about on the grapevine, which supposedly has lots of growth potential. So how do you really know that any company you’re planning to invest in is a worthwhile investment?
What factors are you taking into account as part of your investment decision-making process? There are many factors that contribute to an individual company’s share price, ranging from its own operational performance and management to broader market, sector, economic, and political influences
Even stock market trading professionals, such as stockbroking analysts and portfolio managers, don’t always hit the mark in their own detailed research on which companies to buy or sell.
Factors beyond a company’s control are usually to blame for this.
A recent report by S&P Dow Jones Indices, which evaluated the returns of 936 Australian equity funds over the first half of 2021, found about half of the funds had underperformed the market index they use to measure their investment performance.
The SPIVA Australia Scorecard also found that for longer measured periods (five and 10 years), about 80 per cent of actively managed funds failed to outperform their benchmark index measure.
In addition, almost 55 per cent of international equity funds failed to beat their benchmark index measure over the first half of 2021. Over five and 10-year periods that underperformance figure is closer to 90 per cent.
In a bid to find individual companies that hopefully will deliver them good returns, some investors are turning to paid technology solutions in the form of off-the-shelf computer software programs.
These software programs generally use mathematical algorithms to track stock market trading data, and in some cases other financial data, to identify companies that may have short-term share price growth potential.
They could be companies whose share prices have fallen below their average trading level over a certain period of time, for example over a month, a quarter or a year.
In effect, investors using software programs to try and time when to buy or sell a company’s shares are taking a big risk.
Let’s say a company is currently about 10 per cent below its average trading level in 2021. Based on that data, some stock market software programs will identify that company as a buying opportunity.
But there are likely to be range of reasons why the company’s share price is trading lower.
A company’s historical share price performance has little or no bearing on its future performance.
Rather than recover lost ground, a company’s share price that has fallen over a period of time may continue to fall.
Buying the market
That’s why, rather than hunting for company needles in market haystacks, and even trying to beat the returns of investment professionals by using stock market software systems, more investors are buying managed funds that track the returns of a total market.
They’re doing this by using index-tracking exchange traded funds (ETFs) and managed funds to capture the return of indexes.
Indexes are essentially the benchmarks against which all investment returns are ultimately measured.
For example, while an Australian company’s share price or a superannuation fund’s return may have risen by 20 per cent over the last year, it will have underperformed the 31 per cent gain by the broader Australian market measured by the S&P/ASX 300 Index.
Rather than trying to guess which investments will outperform in the future, index fund managers replicate a particular market or sector.
This means they invest in all or most of the securities in an index that corresponds with the investment purpose of the fund.
There are multiple benefits in using index funds, most notably diversification, because they invest in all or a representative basket of the securities that are included in an index.
This reduces your risk by leaving your portfolio less exposed to the ups and downs of single investments or a smaller number of investment holdings.
By investing in a range of index funds, you can diversify your portfolio across different industries and securities, both in Australia and overseas.
With a broad range of assets in your portfolio, returns from better performing assets can help compensate those not performing so well.
Another key benefit of index funds is cost. Index funds use a buy-and-hold approach, which means their fund managers generally trade securities less frequently than managers who try and outperform the market.
Trading less frequently reduces brokerage, commissions, and other trading expenses.
Also, by tracking the performance of an index, index funds essentially rely on a repeatable investment process allowing for cost efficiencies. Therefore, they don’t have to hire highly paid research teams to analyse and choose securities.
Indexing’s buy-and-hold approach is a low-cost way to tap into the long-term returns generated by investment markets.
As demonstrated by the strong investment markets rebounds from last year’s COVID lows, investors using index funds to gain broad exposure to the Australian share market and international markets have been well rewarded to date.
An iteration of this article was first published in Vanguard’s Smart Investing
https://www.vanguard.com.au/personal/education-centre/en/insights-article/pitfalls-of-stock-picking
Written by Tony Kaye
