Friday, April 18, 2014

So you want to start investing? Look before you leap to picking stocks!

I see posts like these on investing forums like these all the time:

"I'm a [20-something] just getting started at investing.  Here are the stocks I'd like to buy."

or "I'm a [20-something] starting investing.  What stocks should I buy?"

The reply is usually something along the lines of "the stocks you've picked clearly show you know nothing.  You have no business investing right now."  Then that individual tragically gives up when they could have made a head start at getting slow but steady returns using index funds and let compound interest do its work over the decades.  Like I mentioned earlier, it doesn't take much to be an average investor, but if you pick stocks incorrectly, you CAN end up losing a ton of money.

Good news, if you don't know how to pick stocks, you can still invest (and probably should)!  You need to use diversified index funds!  Start with something simple and stable like Rick Ferri's 2-fund portfolio or the Permanent Portfolio on the Boggleheads Lazy Portfolio page.

A monkey can probably pick stocks better than you

When I was in business school, my professors would openly proclaim that a monkey can probably pick stocks better than we can.  Not just novices but monkeys seemed to even beat many seasoned stock pickers as well!  (Now I know a few stock pickers in the industry who have a great track record at picking stocks but I can attest that most probably don't beat the S&P500 in the long run.)

I'll go into more detail on this later but studies show that you only need about 10-20 stocks to achieve most of the benefits of diversification.  So let's say I have 100 readers here pick 20 random stocks and invest 5% in each.  Then I have another 100 learn the basics of stock picking and pick 20 stocks of their choice and even decide on their own weighting scheme (doesn't have to be 5% each.)  5 years later, it is likely that the 1st group will have outperformed the 2nd group as a whole!

Does this mean you should randomly pick 10-20 stocks and be done with it?  The idea of randomly picking stocks and investing your hard earned money in them is a bit disconcerting.  I'd personally stick with Index Funds despite how research shows that random picking and equal-weighting stocks even beats indices like the S&P500.  (For a detailed mathematical explanation, you can check out this article.)

So what should I do?

If you're getting started investing, go with indexing rather than stock picking despite what your friends or the media tells you.  You can get a 2nd opinion from a Financial Advisor if you'd like confirmation that indexing is a wiser choice.  If you're brave and you've read my disclaimer, you can randomly pick 10-20 stocks and equal weight them (for the equities portion of your asset allocation.)  And only play with money you can afford to lose in either case!

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