There is a new standard of financial advice that has crept into the mainstream that says that average is as good as it gets.
The pundits tell us that we should be blissfully pleased with returns equal to those of the masses; that we should blindly follow the herd and invest into low-cost index funds. You really can’t go wrong with this advice – it’s truly great. I have given it. It will work just fine.
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Fine, as long as you have a sufficiently long time horizon for your investments, and you have sufficient resources to allocate to achieve your goals with average returns. Otherwise, it won’t really work.
The philosophy of targeting average returns is based upon a belief that no one gets above-average returns. Believing there can be only average and below average returns is akin to believing that you can put everyone on one side of a teeter-totter and have it balanced. Sometimes, truth leads you to a false conclusion.
First, the truth: active fund managers do not consistently outperform their benchmark indexes for extended periods of time after subtracting fees.
The false extrapolation: I can’t do it, therefore no one else can. Fund managers who deal in the hundreds of millions of dollars face many constraints. Larger sums will naturally produce returns more towards the average. They also need to meet short-term performance targets, have a consistent performance and minimize volatility. As a result, their ability to generate long-term above-average returns diminishes.
You personally are under no such compulsions. Your ability to generate long-term above-average returns is limited by your time and your ability to do the research, as well as your emotional fortitude to hold when you need to hold, fold when you need to fold, and keep your emotions in check.
There are very good reasons not to pursue average. Here are my top seven reasons to invest in individual stocks:
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Stocks provide the best opportunity for long-term appreciation. Period. Some individual stocks will outperform the averages, others will not. Some portfolios of individual stocks will outperform the averages. Others will not.
No matter what fund managers do, some investors will have stock portfolios that outperform the indices. Every. Single. Year.
Even low-cost funds have costs. No-load funds have costs. A buy-and-hold strategy for individual securities can be the lowest-cost growth portfolio you could have. Managed correctly, your costs can approach zero. And they can be very low with a minimal amount of work.
Fund managers buy investments to help them meet the objectives of the portfolio. When you are your own fund manager, you control the quality of the holdings in the portfolio. No one is purchasing some junk to try to boost short-term returns. Nor are they selling a blue-chip stock to do so.
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This is especially pertinent for non-qualified accounts.
As your own portfolio manager, you have complete control over the tax consequences of your portfolio.
Some mutual funds are efficiently managed from a tax standpoint, but you can do more. You can take losses if it is a good time, or hold stocks past year-end to avoid recognizing gains. You have the control.
The primary reason people do not invest in individual securities is the risk. They perceive the risk to be excessive. But there is a close relationship between risk and return. Even if you decide to go with one of those low-fee, everyone-else-does-the-same-thing index fund portfolios, you can still use individual stocks as a portfolio driver. Invest a smallish portion of the portfolio in stocks that you have a very good reason to believe will outperform the market.
If you are right, you can boost your overall return significantly. If you are wrong…
Well, let’s hope you bought a couple different stocks in different industries for different reasons and the down side need not be disastrous.
Take advantage of your knowledge. This is not to say insider knowledge, which most of us don’t have and is illegal to trade on, anyway. But you do have expertise.
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Expertise in some aspect of your life, whether related to your work, to a hobby, or to something you just find interesting to follow. This knowledge can help you select a portion of your portfolio. You might as well profit off of what you know (or are willing to learn).
Yup. Fun. Investing in stocks can be fun. You can track the companies you are investing in and learn a lot about them – how they are run, who their competitors are, and more. You can do the same with the companies you are considering investing in.
It really can be both fun and a learning experience.
Stocks have consistently produced greater returns than any other asset class across time. There is no reason you cannot learn to be an above-average investor. Learn by reading a lot of books on investing. Scour this website and other financial sites.
Average really is good. But above average is better.
Yes, there is a risk. All investments have some risk. Even those average-return seeking index funds have some risk. But they trade some return away for lower relative risk. That is not the only option. That is not the best option for everyone. It is for some, but not for all.
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