Stop Picking Stocks—Immediately!
Ah, New Year's again, which means it's time for the investment media to remind us that there are fortunes to be made in the stock market—and time for nearly every financial media organization to produce some version of "10 Hot Stocks for 2007!" In the past few weeks, for example, the financial magazines have offered us:
If you delve into the above magazines—and you're not human if the headlines don't make you want to—you'll find that the chosen stocks were handpicked from a universe of thousands, were carefully researched, and, in some cases, were even selected by pros. You will find that the recommendations are the height of reasonable: solid companies in growing industries with reasonable price-earning multiples (implication: investment magazines aren't like those idiots recommending Google). The conclusions will sound so compelling, in fact, that you might feel like a fool if you do not buy the 10 Stocks To Buy Now.
Rest easy. If your New Year's resolution was simply "rebalance my portfolio of low-cost index funds," you are displaying more investment wisdom than all of the magazines combined. Whatever you do, do not buy the 10 Stocks To Buy Now, at least not because you read about them in some magazine. If you want to buy the magazine, fine, just don't buy the stocks.
First, because the only reason to buy individual stocks instead of funds is to try to beat the market, and there is no evidence that magazines are any better at selecting stocks that will do this than anyone else. Decades of research have shown that it is so difficult to beat the market that the odds that a professional investor will do it are between 1-in-4 and 1-in-40 (the difference depends on criteria, time horizon, start- and endpoints, and other factors). Common sense and anecdotal evidence, meanwhile, suggest that professional magazine editors are probably worse at picking stocks than professional money managers, if only because money managers pick stocks for a living and magazine editors don't. (Who would you rather hire to kick a game-winning field goal for your football team? A professional place-kicker or a sportswriter?)
Second, anything you read in an investment magazine (or hear on investment TV or radio) was "in the market" the moment the story appeared. This means that, by the time you read it, several thousand professional investors who follow investment news 24/7 will have already scanned it and tossed it in their overflowing trash cans. The average professional will already have known at least 10 times as much about each of the 10 Stocks To Buy Now as the reporter who wrote the story. If, however, by some miracle, the reporter stumbled upon a persuasive fact or insight that previously eluded the money manager, it's a safe bet that the manager will instantly have acted on it. It's also a safe bet that any pro who contributed an idea to the magazine's stock-selection process will already have acted on that. And the pros will no doubt be very tempted to sell into the price surge created by any doctors and dentists (e.g., you) who rush to place buy orders when the latest issue of Fortune, et al., finally hits their desks.
Third, articles touting "10 Stocks To Buy Now" invariably ignore transaction costs, which are one of the major differences between investing in the real world and investing in the you-too-can-be-Warren-Buffett dream world of the investment media. Transaction costs include not only brokerage commissions, but bid/ask spreads, taxes, research, and opportunity costs (what you sold or did not invest in to buy the 10 Stocks to Buy Now). Worrying about transaction costs is often considered wimpy ("Just pick ten-baggers, dude"), but they cripple returns. If some of those 10 Stocks to Buy Now do outperform the market, therefore—and some of them undoubtedly will from luck alone—they need to outperform it by more than the costs you will incur by buying and selling them.
Fourth, in the hierarchy of intelligent-investing priorities, stock-picking is your least important consideration, not your most important. Regardless of how attractive the 10 Stocks to Buy Now sound, therefore, your overriding priority is to make sure you are adequately diversified. Before you even consider buying the 10 Stocks, therefore, you need to determine how adding them to your portfolio will affect its overall diversification and risk/reward profile. Will they make it more risky? Less? Will they increase the expected return? Decrease it? Will they increase the expected return enough to justify any added risk? If you don't know the answers to these questions, you won't be alone. Assessing a portfolio's risk/return profile is complicated enough that most pros buy fancy software to do it. If you're going to let a magazine pick stocks for you, you should get such software, too.
Not all the advice in the "Where To Invest in 2007" magazines is bad. Money, for example, admirably recommends a Vanguard index fund as one of its "best investments," and many other articles provide excellent economic and market overviews and tactical personal-finance advice. Yahoo! Finance's columnist, Ben Stein, even offers exclusively good advice (continue to add money to your portfolio of low-cost index funds), showing that giving good advice does not lead to investment-media-career suicide. Still, it's also no mystery why the magazines run variants of the 10 Hot Stocks articles every year, even though they contain terrible advice: because stock-picking is fun, because such headlines sell magazines, and because investor hope springs eternal.