I suspect that many investors don’t appreciate what’s really involved in beating the market on one’s own. Granted, I can’t blame them. After all, they’ve been told by countless marketers that it’s not only possible but easy.
A little background
Generally speaking, for any investment, the current market price reflects the market’s consensus of the value of all of the future cash flows that will come from that investment.
So for a stock, the current share price reflects the current value of all of the future dividends that the stock is expected to pay.
What’s important to note here is that, for a given stock, there’s a certain level of earnings growth already built into the price. If the company’s earnings in the future exactly match the market’s expectations, then owning the stock should provide a rate of return roughly equal to that of the entire stock market.
If the company’s earnings end up falling short of the market’s expectations, the stock will underperform the market. And if the company’s earnings surpass the market’s expectations, the stock will outperform the market.
In other words, whether the company is doing well or doing poorly is irrelevant. What matters is how well the company is doing compared to how well it was expected to do.
What you need to do to beat the market:
So in order to pick stocks that outperform the market, you need to know two things:
- What the market’s expectations for the company are, and
- Whether those expectations are too high or too low.
Knowing that the company is going to grow over the next [period of whatever length] is completely meaningless unless the rest of the market doesn’t already know that as well. In short, you need to have information that the rest of the market doesn’t have.
Is it possible? Sure.
I’ll freely admit that over an investor’s lifetime, there are likely to be a handful of scenarios in which he or she really does have information about a company that the market hasn’t yet responded to. If you find yourself in such a position, then go for it. Go ahead and buy (or sell) that stock. (As long as you’re not violating insider trading rules, that is.)
Building an entire portfolio?
I do, however, have significant doubts as to whether an investor is likely to be privy to such information often enough to be able to build an entire diversified portfolio out of individual stocks.
My suggestion: Don’t push it. Don’t invest in any individual stocks unless you can honestly state that you know something the market doesn’t. (And don’t underestimate the depth and breadth of the market’s knowledge.)
Instead, fill up the (large) remainder of your portfolio with low-cost, diversified mutual funds.
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{ 2 comments… read them below or add one }
All you have to do is choose the right stock
Great post! I agree with you about building your portfolio around funds. It’s boring, but over time it works rather well. And I’ve lost less in my portfolio this time around than many of my stock picking acquaintances.
Another zinger Mike.
I find it fascinating that many folks will agree with you for years and years and then it happens. They get a call from an uncle or hear something on the radio and the wisdom goes out the window. The only solution is to continue to talk about this subject. Thanks for doing your part.