Picking Stocks vs Investing In Index Funds

New York Times Your Money columnist Ron Lieber wrote an interesting article Picking Stocks After Facebook. He had someone look up the best performing stocks since 1982 in the Wilshire 5000 Index, which is basically everything except very tiny ones.

It turns out that most of the best performing stocks are largely unknown (to me anyway). Here are the top 10:

  1. Home Depot
  2. Kansas City Southern
  3. Danaher
  4. Apco Oil & Gas
  5. Eaton Vance
  6. Gap
  7. Precision Castparts
  8. Raven Industries
  9. TJX Companies
  10. Hollyfrontier

Even today, I only heard of Home Depot, Eaton Vance, Gap, and TJX Companies. That’s 4 out of 10. Back in 1982? Probably none. Would I have picked these 10 if I were investing in 1982? Of course not. From this, the article concludes that you are better off investing in index funds than picking stocks.

While I don’t disagree with the conclusion — I invest in index funds, not individual stocks — there’s also a logical flaw in the argument.

The argument goes like this:

(A) If you were able to pick the top 10 stocks, you would beat the index.

(B) You could not have picked the top 10 stocks because you didn’t even know about those companies.

(C) Therefore picking stocks will not beat the index. Invest in index funds instead.

I had to look it up. The flaw is called denying the antecedent:

If P, then Q.

Not P.

Therefore, not Q.

Picking the top 10 stocks isn’t the only way to beat the index. Therefore the inability to pick the top 10 stocks doesn’t prove that picking stocks is an inferior strategy. We need other evidence.

Does this mean picking stocks is a better strategy than investing in index funds? Of course not. It would be another fallacy if we reach that conclusion. One piece of evidence not proving it poor doesn’t mean it’s better.

It’s also very similar to the stats about missing the 10 best days in the stock market:

(A) If you missed the 10 best days, your performance would suffer greatly.

(B) It’s impossible to tell which days will be the 10 best days.

(C) Therefore you should stay in the market at all times.

This is equivalent to

Staying in the market at all times will make sure you won’t miss the 10 best days.

Market timing means you are not staying in the market at all times.

Therefore market timing will lead to poor performance relative to the market.

We see "denying the antecedent" again. Not that market timing is a great strategy, just the "missing the 10 best days" argument doesn’t prove it’s a bad one.

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Comments

  1. Bill Bull says

    Is ‘the best performing stocks since 1982′ really the best starting point for this letter?
    Wouldn’t it be more useful to start from october 2008 e.g.?
    Since the last crash on the markets so many new players entered the market and they are using so many new technics that even the old adagios are no longer valid.

  2. FOLLOWMY529.COM says

    I am also a fan of investing in low-cost index funds. One just has to ensure you are buying funds of the index you want exposure to and the fund tracks that index properly. On a side note, the “market” is whatever an investor wants it to be (‘index’). The popular S&P 500 Index is weighted according to market capitalization. You can invest in the same 500 companies, but with an equal weighting. Or, another 500 companies picked on some fundamental analysis. Point being, know what you are investing in and not all index funds are created equal.
    With that being said. I do think investing in individual stocks can play a role on one’s total investment plan. Thinking you are going to choose the 10 best stocks since 1982 (or 1981 or 1983) is not realistic. If an investor has the time, knowledge (or eagerness to learn) and a suitable risk profile, dividend paying stocks can be a nice vehicle over the long-term, especially in a drip style account (either through the companies themselves or a service like Sharebuilder). This will take more work than an index fund but can be rewarding for the right investor.
    If someone wanted to pick the next 10 stocks, I would start with U.S. companies that have increased their dividends for at least the last 5 years. Meaning, they actually increased their dividend through the worst recession in recent times. Check out the The DRiP Investing Resource Center (http://dripinvesting.org/), look under Info/Forms/Tools for the Excel spreadsheet and review the list of Challengers. These stocks require homework and reading of income statements, balance sheets and most importantly cash flow statements on a quarterly basis.

    If an investor is looking for a fund to complement the S&P 500 Index fund, the MP 63 fund (ticker: DRIPX) would be a nice addition. http://finance.yahoo.com/echarts?s=DRIPX+Interactive#symbol=dripx;range=my;compare=vfinx;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined;

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