Why the world's greatest stock picker stopped picking stocks.

How to lose your money fast.
Jan. 22 2007 4:14 PM

Stop Picking Stocks—Immediately!

Why the world's greatest stock picker stopped picking stocks, and why you should, too.

Click here to read more of Henry Blodget's Bad Advice.

The most dangerous investment advice is often that which seems most sensible, which is why the worst investing counsel you will likely ever receive is that you should try to pick "good" stocks and sell "bad" ones. You will get this advice in one form or another from innumerable sources, including (some) investment advisers, friends, colleagues, Wall Street, and the investment media. You should ignore it.

Since the dawn of investment time, great stock pickers (there are some) have been revered, and even most novices can proudly recite picks that have produced mountainous returns. ("I bought Google at $85!") Unfortunately, what is smart (or lucky) on occasion often proves dumb over time, and, in the end, most stock pickers do worse than if they had never tried to pick stocks at all. Despite snagging the occasional ten bagger, for example, even professional mutual-fund stock pickers still have depressingly poor odds of beating the market once their losers and costs are taken into account (between 1-in-4 and 1-in-40, depending on how you measure performance). If you pursue a stock-picking strategy, you are almost certain to lag the market.

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The problem for investors is that even though stock-picking usually hurts returns, it's extremely interesting and fun. If you are ever to wean yourself of this bad habit, therefore, the first step is to understand why it's so rarely successful. The short answer is that the overall market provides most investment returns, not particular stock picks, so most stock pickers get credit for gains that came merely from being invested in stocks generally. Second, competition among stock pickers is so intense that it is extraordinarily difficult for any one competitor to get a consistent edge. Third, although it is relatively easy to pick stocks that beat the market before costs (all else being equal, you have about even odds of doing this), it is much harder to do so after costs. Even if you pick stocks well enough to boost your pre-cost return by a couple of points, the expenses you rack up along the way (research, trading, taxes, etc.) will usually more than offset your gain.

Most stock pickers believe that they are among the tiny minority of investors who can beat the market after costs, and, for inspiration and encouragement, they point to legends such as Warren Buffett and Benjamin Graham. What such investors often don't know is that even Buffett has said that the best strategy for most investors is to buy low-cost index funds and that the great Benjamin Graham eventually changed his mind about the wisdom of traditional stock-picking. Graham, you may remember, is considered one of the greatest stock pickers of all time, the man who, in the 1930s and 1940s wrote two classics on intelligent investing and whose security-analysis techniques are still taught in most serious investment classes. But in 1976, shortly before his death, Graham told the Journal of Finance the following:

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when [the bible of fundamental stock analysis, Graham and Dodd's Security Analysis] was first published; but the situation has changed. I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost.

What did Graham mean when he said that "the situation has changed"? Why did he conclude—more than three decades ago—that stock-picking practices that had defined intelligent investing in the 1930s were, by the 1970s, no longer worthwhile?

First, in the seven decades since Graham wrote Security Analysis, the stock market has gone from being a playground for amateurs to a battlefield dominated by full-time professionals. One result is that pricing errors that once might have gone unnoticed for months in Graham's day are now discovered and exploited instantly. Second, the amount of information available about the most obscure stock today dwarfs what was available about even the bellwethers a half-century ago, making it harder to dig up information that other investors don't know. The moment the information is released, moreover, it is dissected, discussed, and debated by thousands of analysts, until most reasonable conclusions that can be drawn from it have been. Today's technology also allows even part-time investors to screen tens of thousands of stocks in dozens of markets in the time it would have taken a Graham-era analyst to compute the "net current assets" of a single company.

Third, inside information that used to be quite valuable is now illegal to trade on. And, finally, the establishment of research centers such as the Center for Research in Security Prices (CSRP) has allowed analysts to study markets and investing in ways that the young Benjamin Graham could only have dreamed of—and, in so doing, to assemble a body of knowledge that makes much of the "investment wisdom" of the early 20th century seem as primitive and unscientific as bloodletting.

Benjamin Graham's "deathbed" quote is occasionally taken to mean that he completely repudiated his former work by suggesting that stock analysis is worthless. In fact, he just advocated a more diversified and high-level stock selection strategy. Specifically, Graham recommended screening stocks using simple valuation and fundamental criteria and then buying large groups of them, the same way a modern "passive" fund (such as a value-oriented index fund) does. What Graham did "recant" was the idea that by studying companies in detail, one could identify a few super-promising opportunities that could safely deliver market-crushing returns.

The stock-picking mystique is so deeply entrenched in our financial culture that it feels like heresy to suggest that it is, on balance, dumb. The facts are clear, however. For the vast majority of investors—including professionals—stock-picking efforts waste both money and time.

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