We met with a client yesterday who enjoys carving out a small portion of his portfolio and speculating on stocks. It's not my preferred way of doing things, but it keeps the client happy and engaged in his own investment strategy.
For a lot of people, even if they acknowledge the science behind efficient markets (which is pretty much like acknowledging the science behind gravity), they're just bored by a diversified portfolio that doesn't change much over time. They need some more excitement mixed in with their investing.
I get it. On some level, it was a lot of fun back when I taught stock trading and wrote about it for Investor's Business Daily. There's a steady stream of new, interesting companies popping onto screens. I was tracking IPOs. Earnings season was a roller coaster, but it always got my adrenalin flowing. You could be pleasantly surprised, as I was with Green Mountain Coffee Roasters (GMCR), or crushed, as I was with Crocs (CROX).
I believed that stock picking was the only way to beat the market. As I've written before, when the market is defined as the S&P, then, yes, you will see small-caps and value stocks beat the market in some quarters. But if you make the claim that your small-caps are beating the S&P, it's kind of nonsensical, because you're using the wrong benchmark.
In addition, it's fairly easy for trading-system purveyors to massage their performance to reflect the best possible returns. Remember, they are not fiduciaries and are not held to the same standard as advisors or even mutual fund companies. Enough said on that topic.
Eventually, I was introduced to empirical, rather than cherry-picked, data. The data show that persistent and consistent returns, over time, beat stock picking.
So that brings me back to my client. I work for him. Remember that thing about being a fiduciary? My job is to help him reach his objective, which is a secure retirement.
But because I work for him, it also means that I have to engage him in a way that works for him. A lot of clients come in with a pile of stocks, but have no particular attachment to them. The stocks just sit there like lumps of coal. In those cases, we immediately get to work selling and getting the clients into some diversified models with an expected return to meet their goals.
But with my client yesterday, I wouldn't recommend that he sell his stocks. That would be disrespectful to his viewpoint. Only a tiny slice of his portfolio (10%) is allocated to single stocks. He understands this and is hoping he'll have a few bets that can add alpha to his diversified fund portfolio. We help him hone these bets into something with higher probability of success, based on market cap, fundamentals and, yes, some technicals. (Hey, I didn't spend 10 years at IBD to completely forego my technical analysis training!)
But with the speculative portion of your portfolio, position sizing is key. You don't want one bet to get out of whack and cause damage to your strategy. The key is that your speculative bets should do no harm to your strategy. If you're lucky and careful, they might even help once in a while.