I am a huge fan of Warren Buffett, who justly deserves to be known as the Oracle of Omaha. His company, Berkshire Hathaway, increased its book value by 20.3 percent annually for the past 44 years—an astounding record. In the decade from 2000 to 2010, Berkshire Hathaway stock returned 76 percent. The S&P 500 lost 11.3 percent during the same period.
But things have not gone as well this year. The stock opened 2011 at $80.11. Its last quote was $76.90, representing a year-to-date loss of 4 percent. During the same period, the S&P 500 index was up 6.85 percent.
Investors in Berkshire Hathaway may, or may not, recover their losses. No one knows. What we do know is that trying to pick stock winners is very risky business. The expected return of any stock is about the same as the index to which it belongs. However, because of concentration risk (having all your eggs in one stock basket), the risk of holding an individual stock can be as much as twice as great as buying the index. When you understand this additional risk, you will avoid buying any individual stock.
Still not convinced? If your broker is recommending the purchase of a particular stock, he has to be assuming it’s mispriced. What is the basis for that assumption? All information about publicly traded stocks is instantly available to millions of traders around the globe. The global marketplace incorporates this information into the price of the stock. As one of my colleagues is fond of saying: It’s baked in the cake.
The price of any stock today reflects the collective judgment of all of these traders. It’s likely to be a fair price, which is neither too high nor too low. Ask your broker what he knows that all of these traders are missing. Remember, if you are buying, someone else is selling. Is it really a foregone conclusion that the person on the other side of the trade is at an informational disadvantage?
Picking sectors or asset classes that are likely to outperform is also a crap shoot. There is no persistency from one year to the next. Big winners or losers in one year can have markedly different returns the next. For example, discretionary consumer products returned 22 percent in 2006 and then lost 3 percent in 2007. The financial sector lost 38 percent in 2008 and gained 6 percent in 2009. Manufacturing gained 21 percent in 2007 before declining by 41 percent in 2008. Trying to pick stock winners or sector winners is not investing. It’s gambling.
Here’s the ultimate irony. Your focus on stock picking, mutual fund manager picking, and market timing is a classic case of having your eye on the wrong ball. By far the primary determinant of your returns is the percentage of your portfolio allocated to stocks. Exposure to small company and value stocks can also impact your returns. Three factors—market, size, and value— explain 96 percent of the returns in a diversified portfolio. The balance is unexplained. Think about this data the next time your broker suggests buying any individual stock—even one managed by the Oracle of Omaha.
Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.