Investing 101: Picking stocks (and why it’s a bad idea)
This article is part 5 of the Investing 101 series. As a quick recap of the series so far, we talked about what investing means, why people should invest, what stocks are, how stocks are priced, and finally, what the S&P 500 and other market indices represent.
Now, lets go from the theoretical topics to more practical ones. Originally, this article was going to cover mutual funds and index funds. However, the article became far too long, so I’ve split it in two. Mutual funds are the most popular type of investment product in the world. But before we dive straight into funds, we need to understand the main reason that these funds exist at all: stock picking is very challenging.
Picking stocks is hard, and you can’t do it consistently
This is the simple truth about stock picking. It has been echoed by some of the most pre-eminent investors and economists of our time. Anyone who tells you differently is probably trying to sell you a course or a scheme. But many investors are tempted to try their hand at stock picking, so it’s only appropriate to look at why stock picking might not be a good idea.
Let’s rewind 10 years. The year is 2011. The global financial crisis is finally over. You decide it’s a good time to start investing. There are thousands of publicly-traded companies in the United States, and each year, even more companies go public. It’s hard to know what companies to choose, so you decide to invest in some rock-solid, household names, so-called “blue chips”, that you are familiar with: General Electric, Sears, Kodak, and Ford. For fun, you also take a risk on a relatively new start-up company that just went public, Groupon, because literally everyone you know is using it to try out new experiences on discount, and in return, the vendors get more exposure and new customers. So all in all, you picked four iconic American businesses and an exciting tech start-up whose business model seems to be a win-win for everybody.
Fast forward 10 years to today (2021). Let’s see how your stock picks did:
Oops. All 5 picks turned out to be terrible. Sears is now bankrupt and the rest are struggling. While the other 4 are not bankrupt (yet), only Ford remains a profitable company.
But that’s unfair, I would never have picked those 5 losers in the first place!
Obviously, with the benefit of hindsight, it’s easy to say that these companies were poor picks in 2011. For example, maybe you already knew in 2011 that online shopping would replace retail, so you would have never invested in Sears, which was already in trouble. But it’s not so simple, because other retail stores, such as Costco and Home Depot, have done incredibly well in the past decade:
You might argue that Home Depot is an exception because it sells things that aren’t easily bought online, such as lumber. But Sears sold lumber. And appliances. And cars, campers, and tractors. And even entire mail-order, pre-fabricated houses. At various parts of its history, Sears sold literally everything under the sun.
Older folks might remember that Sears had a catalogue that was once the largest mail-order catalogue in the country. It was sent to millions of households and you could order just about anything you wanted from it. It was literally Amazon.com before the internet existed. Being a retail store in the internet age is not the reason that Sears failed.
By 2011, Sears was already in trouble, as were many other traditional retail stores. But there was definitely some cautious optimism that board chairman Eddie Lampert, who had taken K-Mart out of bankruptcy, could do the same with Sears. Unfortunately, it didn’t happen. But even as late as 2016, there were articles arguing that Sears was a “once-in-a-lifetime investment opportunity”. Two years later, Sears filed for bankruptcy.
What about winners in the past decade?
My point is that bad picks are always obvious in hindsight, but never at the time you pick them. But the same goes with picking winners. Of course, it’s no secret that technology companies have outperformed just about everything in the digital age. You might tell me that instead of the stupid picks of Ford, GE, and Kodak, and Sears, you would have invested in Apple, Netflix, and Amazon instead:
Cool, except we have a couple of problems. First, you didn’t invest in these stocks in 2011, because if you did, you are probably not reading blogs about investing in 2021. Instead, you are sipping a refreshing cocktail while relaxing on an exotic beach somewhere. Second, we can’t go back in time to invest in these stocks. Third, many tech companies have not done well (again, look at Groupon). And finally, none of the hindsight helps us make future decisions!
It can be almost impossible to distinguish a future winner from a future bankruptcy. What did Sears and Netflix have in common in 2011? Both were in trouble. In fact, Netflix almost went bankrupt in 2012. It was one of the most heavily shorted stocks on the market (along with, you guessed it, Sears - heavy short selling typically indicates lack of investor confidence as people are betting that the company will go under. See my GameStop article for a more recent example and a more in-depth explanation of short selling). Netflix lost almost 1 million subscribers in 2012, its stock lost over 80% of its value, and its future was far from certain. But it did turn its business around and became a darling of the tech world.
Of course, with the benefit of hindsight, we now know its trivial to pick any of the tech giants known collectively as the “FAANG” companies (Facebook, Apple, Amazon, Netflix, & Google) as examples of great investments in the past 10 years. These same companies are now some of the most valuable in the world. But this wasn’t so obvious in 2011, only about a decade removed from the dot-com crash.
And finally, just to drive my point home: even with all the hindsight in the world about how dominant technology companies were in the past decade, did you know that a pizza restaurant outperformed every single FAANG stock in the past 10 years?
Yeah. Domino’s Pizza was a better investment in 2011 than Apple, which changed the world with the iPhone. Here is a list of a few selected stocks and how much $10,000 invested in January 2011 would be worth 10 years later in March 2021:
| Stock | Growth of $10,000 from 2011 to 2021 | CAGR |
|---|---|---|
| Apple | $171,893 | 31.98% |
| Amzn | $123,115 | 27.75% |
| GE | $9,801 | -0.20% |
| Ford | $10,767 | 0.72% |
| HD | $110,170 | 26.38% |
| Sears | $0 | -100% |
| Dominos | $272,182 | 38.03% |
CAGR stands for Compound Annual Growth Rate, which is an expression of the annualized returns of an investment (if returns were constant). I have an article that explains CAGR in more detail here.
Even with hindsight, can you believe that Domino’s Pizza was one of the best stocks to buy in 2011?
Admittedly, I’ve cherry-picked my examples to drive my point across. But if you want to invest, you have some tough decisions to make. It is now 2021. Which stocks do you pick today? I’m guessing that you’re not buying up shares of your local pizza restaurant hoping it is the next Domino’s. Instead, you’re probably more comfortable buying the likes of Apple, Amazon, and Home Depot. While these are great companies now, ironically, they might also become the GE, Sears, and Kodaks of the next few decades. The point of this exercise is that picking stocks is hard. You cannot foresee which companies might embrace new technologies, new markets, and new opportunities, and which ones will get left behind. And as we’ve seen with the likes of Sears vs. Home Depot, Netflix vs. Groupon, and Dominos, any company, in any sector, can succeed or fail in any economic climate. You would have been laughed at if you said, back in 2011, that the “next big thing” was “pizza” instead of “4G LTE” or “streaming”. It is impossible to know anything about the future, and people who try to tell you that they know the “next Apple” or “next Amazon” always have an ulterior motive.
This section was added on 4/28/22, about one year after this article was originally written. I wanted to provide an update on one of my previous examples. Netflix’s stock price reached a peak of over $600 by November of 2021. Since that time, however, Netflix’s stock price crashed precipitously. These losses accelerated in 2022, following news that it had lost 200,000 subscribers, its first quarterly subscriber loss in a decade. As of 4/28/22, Netflix’s stock price is $188, meaning that it has lost over 73% from its peak in November 2021 in the span of just five months.
Netflix stock price as of 4/27/22, showing decline in 2022.
Will Netflix recover from this latest setback, or will it succumb to an increasingly crowded streaming space and cede more subscribers to the likes of Hulu, HBO, and Disney+? Will it eventually go the way of AOL and Blockbuster, companies which at one time dominated their respective industries? I have no idea. Netflix’s example, however, perfectly illustrates the difficulties of individual stock picking.
With even longer time horizons, picking winners is almost impossible
At least with a 10 year time period, we have some hints as to which companies might do well in the near future. For example, Apple released the first iPhone in 2007, and it quickly caught on like wildfire, ultimately starting a technological movement that spawned entirely new industries. Therefore, it was conceivable in 2011 that Apple would do very well in the next decade. Apple is now the largest company in the entire world by market capitalization. But what will happen over the next 30 years? When we extend the time period, pretty much everything goes out the window.
Recently, during its annual Berkshire Hathaway shareholder meeting held on May 1st, 2021, Warren Buffet, probably the great investor of all time, shared some interesting slides in his presentation. Despite being the most successful active investor in history, Buffet has consistently shared the opinion that stock picking is difficult, if not impossible, for the average investor, and he is a strong advocate for index funds such as an S&P 500 index fund. During his opening remarks, he showed a list of the top 20 largest companies in the entire world, by market capitalization, as of March 31, 2021. I don’t have Buffet’s actual slides, but I have reproduced the list here:
| Twenty Largest Companies By Market Cap on March 31, 2021 | ||
| Country | Company | Market Cap, $ USD |
| U.S. | APPLE | 2.05T |
| SAUDI ARABIA | SAUDI ARAMCO | 1.92T |
| U.S. | MICROSOFT | 1.78T |
| U.S. | AMAZON | 1.56T |
| U.S. | ALPHABET | 1.39T |
| U.S. | 838B | |
| CHINA | TENCENT | 752B |
| U.S. | TESLA | 641B |
| CHINA | ALIBABA | 614B |
| U.S. | BERKSHIRE HATHAWAY | 587B |
| TAIWAN | TAIWAN SEMICONDUCTOR | 534B |
| U.S. | VISA | 467B |
| U.S. | JP MORGAN CHASE | 464B |
| U.S. | JOHNSON & JOHNSON | 432B |
| KOREA | SAMSUNG ELECTRONICS | 430B |
| CHINA | KWEICHOW MOUTAI | 385B |
| U.S. | WALMART | 382B |
| U.S. | MASTERCARD | 353B |
| U.S. | UNITED HEALTH | 351B |
| FRANCE | LVMH MOET | 336B |
A few things worth noting, some of which Warren Buffet pointed out: Saudi Aramco is state-owned (98.5% of shares are owned by the Saudi government), so while it is technically possible to buy shares in it, it is not a public company in the traditional sense. Five of the top six companies are American, and thirteen of the top twenty are American. All of the American companies on this list are public companies, and all are included in the S&P 500. Buffet went on to praise American businesses - he has always been staunchly patriotic.
Buffet then posed an interesting question: out of these twenty companies, how many will still remain on this list, 30 years from now? You might guess five, or eight, or some positive number. Surely, all of these companies represent the pinnacles of their respective industries, and won’t be going away anytime soon.
The answer, of course, is nobody knows. But for some historical context, Buffet’s next slide presented the top twenty largest companies in the world, by market capitalization, 30 years ago in 1989:
| Twenty Largest Companies By Market Cap, 1989 | ||
| Country | Company | Market Cap, $ USD |
| JAPAN | INDUSTRIAL BANK OF JAPAN | 104B |
| JAPAN | SUMITOMO BANK | 73B |
| JAPAN | FUJI BANK | 69B |
| JAPAN | DAI-ICHI KANGYO BANK | 64B |
| U.S. | EXXON CORP | 63B |
| U.S. | GENERAL ELECTRIC | 58B |
| JAPAN | TOKYO ELECTRIC POWER | 56B |
| U.S. | IBM CORP | 55B |
| JAPAN | TOYOTA MOTOR CORP | 53B |
| U.S. | AMERICAN TEL & TEL | 48B |
| JAPAN | NOMURA SECURITIES | 46B |
| NETHERLANDS | ROYAL DUTCH PETROLEUM | 41B |
| U.S. | PHILIP MORRIS CO | 38B |
| JAPAN | NIPPON STEEL | 36B |
| JAPAN | TOKAI BANK | 35B |
| JAPAN | MITSUI BANK | 34B |
| JAPAN | MATSUSHITA ELECT IND'L | 33B |
| JAPAN | KANSAI ELECTRIC POWER | 33B |
| JAPAN | HITACHI LTD | 32B |
| U.S. | MERCK & CO | 30B |
Clearly, the world was a much different place 30 years ago. Japanese companies were over-represented on this list because coincidentally, 1989 was also near the peak of the Japanese asset price bubble, a devastating over-valuation of Japanese assets followed by a subsequent collapse when that bubble burst. Many Japanese asset prices have still not recovered, 30 years later.
There were 13 Japanese companies on this list in 1989. Today, there are none. There were 6 U.S. companies on this list in 1989. Today, all 6 companies still exist, but none of them remain in the top twenty. In fact, none of the top twenty companies in 1989 remain in the top twenty, 30 years later. Warren Buffet went on to say:
”I would invite you to think about one other thing as you look at this list. 1989 was not the dark ages. I mean, we weren't just discovering capitalism or anything else. And people thought they knew a lot about the stock market and the efficient market theory was in. And they were all… it was not a backward time. And if you look the top company at that time had a market value of a hundred billion, 104 billion. So the largest company in the world… of title in just a shade over 30 years has gone from a hundred billion to 2 trillion.
And at the bottom, the number 20 is gone from 34 billion to something little over 10 times that. Well, that tells you something about what's happened with equality, which is a hot subject in this country. And it tells you a little bit about inflation, but this was not a highly inflationary period as a whole. But it tells you that… that capitalism has worked incredibly well, especially for the capitalist. And it's a pretty astounding number. You'd think it could be repeated now that 30 years from now that you could take 2 trillion for Apple and multiply any company and come up with 30 times that for the leader. Yeah, it seems impossible and maybe it is impossible, but we were just as sure of ourselves as investors and Wall Street was in 1989 as we are today, but the world can change in very, very dramatic ways.”
Buffet’s point, I think, is that we cannot predict the future. If this list has shown us anything, it is that the world will look even more different 30 years from now. The largest company in the world in 2051 might not even exist today. Picking the best stock of the future is impossible. And it probably won’t be any of the high-flying technology stocks of today.
It is better to diversify by investing broadly
Clearly, investors face a dilemma when it comes to picking stocks. Some stocks will provide tremendous returns to the investor. Other stocks will not. It is not possible to know, ahead of time, which stocks are winners and which stocks are losers. Unless you want to gamble with your life savings, putting all your eggs in one basket is a bad idea. But as we have already proven, not investing is not an option. We’ve also seen that collectively, the value of the overall stock market, as measured by an appropriate market index (such as the S&P 500), keeps growing over time. Therefore, many people believe that the best way to invest in the long term is to invest as broadly as possible, in as many companies as possible, in every sector and industry, and even in multiple countries. This idea is known as diversification. It not only reduces the risk of any particular stock pick going poorly, but it also captures the gains of the unlikely winners of the future.
You can certainly diversify by manually buying shares of dozens, hundreds, or even thousands of companies. This can get incredibly tedious, and back In the days when most brokers charged commissions on stock trades, this also gets very expensive. Also, since you must purchase at minimum one share of each stock, this method can require a lot of capital, as some stocks are quite pricey. Finally, managing a portfolio like this would be a nightmare. Thankfully, with mutual funds and index funds, investors can do exactly this, but without any hassle at all. Therefore, it’s hardly surprising that mutual funds and index funds are the most popular investment products in the world today. In the next Investing 101 article, we will take an in-depth look at these funds. Thanks for reading and happy investing!
