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Don’t Bother Picking Stocks

I suspect that many investors don’t appreciate how difficult it is to beat the market by picking stocks on one’s own. Granted, I can’t blame them. After all, they’ve been told by countless marketers (i.e., hot-stock newsletters) that it’s a surefire road to riches.

What a Stock’s Price Means

The current share price of a stock reflects the market’s best estimate of the value of all of the dividends that the stock is expected to pay over the entire future of the company.

This means that, for a given stock, there’s a certain level of earnings growth already built into the price. How well the stock does is determined by how the company’s actual profits compare to the market’s expectations for the company’s profits.

  • If the company’s profits in the future exactly match the market’s estimates, 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.
  • 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:

  1. What the market’s expectations for the company are, and
  2. 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.)

What do I suggest instead? Mutual funds. Which ones? Low-cost index funds in most cases.

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