As many of my regular readers know, I like to pick my own stocks rather than invest in broadly diversified ETFs and CEFs like the Schwab U.S. Dividend Equity ETF (SCHD) or the Cohen & Steers Quality Income Realty Fund (RQI). While funds certainly come with pros like providing instant diversification, reducing the need for time spent on research and tracking positions, and less risk of allowing emotions to get in the way of rational decision-making, there are also numerous pros to investing in individual stocks. This is particularly true if studying companies and analyzing stocks is something that you enjoy and/or do for a living, both of which apply to me. If you have the right temperament to be disciplined and patient while allocating your capital among individual companies, the rewards of picking individual stocks include the potential to significantly outperform the broader stock market, which also applies to me. I have been blessed to significantly outperform the S&P 500 (SP500) over the years that I have invested my own money.
With that being said, there are some important lessons that I wish I had known before embarking on my stock-picking journey that would have made my experience even more rewarding. In this article, I will discuss three of them.
Stock-Picking Lesson #1
The first big lesson that I wish I had known before becoming a stock picker is that while the market is often wrong, it is never stupid. What I mean by this is that there are many times when the market misprices a stock, and it is either way overvalued, only to later be discovered as such and significantly underperform, or it is grossly undervalued, only to later soar significantly higher. While there are many who claim the market is always efficient-and it likely is pretty efficient on large, well-covered names-my experience has proven that to not be the case for many stocks, especially those off the beaten path. As I have noted, I have outperformed the S&P 500, with annualized total returns that are about 50% higher than what the S&P 500 has generated over my investing career.
However, just because the market may be wrong about many stocks, or even the ones I am investing in, there is still a good reason why it prices stocks as it does. As a result, many times, stocks that seem very expensive can get even more expensive (e.g., Palantir (PLTR) and NVIDIA (NVDA)), and stocks that appear to be dirt-cheap bargains can get even cheaper (e.g., AT&T (T) and Medical Properties Trust (MPW)). As a result, when picking individual stocks, it is really important to do a thorough qualitative analysis of the company and not simply look at the numbers and go solely off of valuation metrics.
Additionally, I have personally decided to never short a stock because the downside is unlimited, and the upside is capped at 100%. As a value investor, it can be very tempting to try to short stocks that appear to be grossly overvalued, but many times when you do that, you miss some qualitative aspects of the company and/or underestimate the exuberance of market sentiment for the company and/or broader sector, which can lead to enormous losses.
Therefore, when I invest in stocks now, I make sure that I do not have too much confidence in my bull thesis and try to keep my positions measured accordingly. Additionally, if there is a large short interest in the stock, or it has been beaten down viciously, I often layer into the stock very gradually, and I constantly second-guess my bull thesis, looking for every possible critique I can throw at it. While being a contrarian and disagreeing with Mr. Market has been the key to my success over the years, it is absolutely essential that I temper my contrarian streak with a healthy dose of respect for the collective wisdom of Mr. Market.
Stock-Picking Lesson #2
The second lesson that I wish I had learned before becoming a stock picker is that achieving a proper balance of diversification in my portfolio is essential. What this means is that while the fewer stocks you hold, the greater your chances of achieving truly remarkable total returns, your chances of achieving catastrophic or poor results also go up. At the same time, if I diversify too broadly, I might as well simply invest in an index fund or an actively managed ETF or CEF because the diversification will be so broad that I will be holding a lot of lower-conviction picks that will likely perform in line with the market or even below the market average, thereby weighing down my total returns.
Additionally, making any sort of intelligent picks when I have a large number of holdings will take up way too much of my time, depriving other important parts of my life, and ultimately costing more in time than any incremental benefit provided by additional diversification. As a result, I have learned that between 15 and 25 picks is a pretty good sweet spot for me because that gives me enough diversification to spread my bets evenly and keep my exposure to any single position below 10%, while still being a feasible number of companies to follow. This allows me to make some sizable bets in my top three to five conviction picks at any one time.
Another important aspect of diversification to keep in mind is maintaining proper exposure to various sectors. As the past several years have shown, there are periods where certain sectors are highly in favor, while others are highly out of favor due to macroeconomic forces or simply market sentiment. As a result, if I become over-concentrated in a single sector-even if I see a lot of value there and have high conviction over the long term-I could suffer heavy losses over a couple of years and miss out on huge gains elsewhere.
For example, if, since early 2022 or early 2023, I had bet everything on REITs (VNQ) and utilities (XLU) while completely avoiding tech stocks (QQQ), I likely would have been clobbered by Mr. Market, even if I had invested in high-quality REITs and utilities trading at compelling discounts. This is simply because higher interest rates during that period hammered interest rate-sensitive sectors like REITs and utilities, with blue chips like Realty Income (O) and NextEra Energy (NEE) delivering weak performance over that period while tech stocks, fueled by an AI boom, sent companies like NVIDIA, Palantir, and Microsoft (MSFT) soaring to new highs.
What this means is that even if I choose to focus on a few key sectors in order to maximize my confidence in a fairly narrowly defined circle of competence, I can still achieve diversification in other sectors by investing in an ETF to enhance my broader portfolio diversification. For example, if a dividend investor wants a high portfolio yield and focuses on picking stocks in sectors like REITs, utilities, midstreams (AMLP), and BDCs (BIZD), they can still have exposure to the tech sector without sacrificing dividend yield. This can be done by investing in a monthly high-yield covered call ETF like the JPMorgan Equity Premium Income ETF (JEPI), which has significant exposure to blue-chip tech stocks.
Stock-Picking Lesson #3
The third major lesson that I wish I had learned before picking individual stocks is that while stock pickers certainly have to have a different mindset than ETF investors in many ways, particularly by being willing to roll up their sleeves, pull out their magnifying glass, and put pencil to paper to do proper stock analysis, as well as actively manage their portfolio to optimize risk and reward at all times, it is also essential to maintain the mindset of an ETF investor. What I mean by that is when you diversify your portfolio based on sector and position, you are inevitably going to have some losers, even some big ones, among your stock picks. When you do, it is important to maintain proper perspective and realize that ETF investors are suffering the same large losses on many of their positions. However, they do not see it firsthand because those positions are part of a broadly diversified portfolio where the winners largely cancel out the losers over time.
Therefore, when managing a portfolio of individual stocks, it is important to view your portfolio as an ETF and remove yourself from the pain and joys of individual major losers and winners. Instead, evaluate your approach based on your aggregate portfolio performance over time. This is necessary in order to remain emotionally detached from your stocks and not become too in love with your winners or too depressed by your losers. This is something I have had to do in particular as an investing group leader, as it is very easy to panic and think I am a complete failure as an investor when one of my stocks-especially one that I had high conviction in-ends up being a major loser like Algonquin Power & Utilities (AQN) was for me. At the same time, it is also easy to think I am a genius when one of your stocks turns into a multi-bagger like Energy Transfer (ET) was for me.
The big lesson here is that maintaining proper perspective, viewing portfolio performance in aggregate, and maintaining a long-term perspective is so important. This keeps me grounded, humble and focused on my process rather than dwelling too much on my highs and lows.
Investor Takeaway
With these three lessons-namely, maintaining a healthy respect for Mr. Market, achieving an optimal balance between concentration in high-conviction positions and adequate diversification, and viewing your overall portfolio like an ETF investor-stock picking becomes much easier and much more fruitful over the long term. Hopefully, these lessons are useful to you, as they have been for me.
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