Despite that the COVID pandemic continues in yet new forms, it is beyond doubt that stocks around the world are in clear uptrends and have been since the March 2020 bottom.
One of the issues that arises when stocks are in strong bull markets like we have seen over the last 18 months is the apparent benefits of stock picking. While an index like the S&P500 has nearly doubled over this short period of time, individual stocks have gained far more, as the chart below indicates.
As a result, it’s tempting for many investors to seek out individual stocks and attempt to outperform the indexes. Strong recent performance in certain stocks even leads to stories in the media about the enormous rates of return that investors would have gained if they had simply held a particular stock, like Apple or Amazon, over very long periods of time.
The problem with an approach like this is that the odds are stacked heavily against the individual investor. As Meb Faber put it in his "Invest Like the House,” from 1983-2007, a very bullish time for stocks, nearly two-thirds of stocks underperformed the broad market index. Even worse, more than one-third of stocks did not earn a positive return at all, and one in five stocks lost at least 75% of its value. Only 25% of stocks were responsible for ALL of the market’s gains during this time frame.
Further, stocks that are the darlings of today, like Microsoft and Amazon, have experienced major declines over long periods of time. Microsoft and Amazon have each returned well over 1000% over the past ten years, but each stock has suffered from major declines that did not resolve until years later. Microsoft, for instance, lost 70% of its value during the entire 2000-2009 decade, and Amazon suffered a 94% decline during the years after the dot-com bubble of the 1990s had burst. It’s hard to imagine that “long-term investors” would be able to tolerate such impairment of their capital over such long periods of time.
This is one reason that to the extent investors want to own individual stocks for the long term, I tell them to “date,” not to “marry” stocks. Today’s winner may easily be tomorrow’s loser, and investors can often conduct their buying and selling at the worst possible time, buying at the top and selling at the bottom.
It’s not that an approach like this cannot succeed. It’s just that the odds are not in favor of the individual investor, and there are clear alternatives that put the odds more in the investor’s favor. One such option is simply to buy a low-cost index ETF or mutual fund. That way, the investor can be assured not to underperform the market by picking the wrong stocks. Individual stocks can go to zero, but not indexes of stocks. This is an approach that has succeeded strongly since the Great Financial Crisis ended in March of 2009.
Another possibility is to buy individual stocks but to protect against a severe decline. One way to do this is to enter a trailing stop-loss order on the stock after it is purchased to avoid a pre-determined amount of decline. A common way to do this is to put a 25% trailing stop order in place. With such an approach, the sell order price increases as the share price increases, minimizing potential loss protecting gain. Even if the stock takes an immediate dive, the worst loss the investor would suffer is a 25% loss. If the size of the position is managed so that a 25% loss in the stock amounts only to a loss of 1-2% of the portfolio, the stock’s dive will not hurt the overall portfolio very much.
Of course, it is also worth pointing out that buying index ETFs and mutual funds carry with them their own risks. After all, stocks declined over 50% during the 2008-2009 Great Financial Crisis and further declined by a similar amount over a three-year period from 2000-2003. These bear markets devastated many portfolios, delaying retirement for many workers and forcing many recent retirees back to work.
But there is a way to avoid losses from investing in index ETFs and funds. The answer is momentum. Momentum holds the index fund when the prices are on the rise and sells it after the prices have begun to fall, avoiding severe losses and gaining ground when stocks are in uptrends.
Momentum can succeed with individual stocks, too, but the odds are better with index ETFs and mutual funds, as Gary Antonacci has shown in his “Dual Momentum” book, which is among my five favorite books on trading and investing.
A few simple, yet effective methods like these can make a world of difference for investors.