ETF Investing Guide: Did Stock Picking Distract You?

A serious, but seldom mentioned problem with buying individual stocks is the distraction from diversification and asset allocation.

Between 2000 and 2002, many investors learned the hard way that holding a relatively concentrated portfolio of solid, reputable, large cap stocks did not provide adequate diversification. Enron, Worldcom, Tyco, Williams and Health South turned out not to be so solid and reputable. Lucent, Nortel and Sun turned out to be reputable but not exactly solid. If your portfolio consisted of 40 stocks and included these eight, you'd have suffered almost total obliteration of a fifth of your retirement savings.

Yet most people, if asked the question "Are you safer owning a thousand stocks or forty stocks?" would answer that they should obviously own a thousand rather than forty. The problem, I suspect, is that by focusing on stock picking many investors forget about diversification, or find it too hard to choose enough stocks to provide adequate diversification.

A similar phenomenon occurs with asset allocation. Academic studies have found that investment returns are largely determined by asset allocation, namely the share of your portfolio allocated to asset classes, such as small cap domestic stocks or foreign bonds. Individual stock selection plays a relatively minor role in determining investment performance. (In a 2000 paper, Roger G. Ibbotson and Paul D. Kaplan actually found that asset allocation accounted for 100% of fund managers' performance.)

Yet many investors are totally ignorant about the proportion of their portfolios devoted to each asset class. Even if they are adequately diversified in terms of the number of stocks they own, they often still fail to diversify accross different sectors, types of stocks, and between asset classes. You may have two hundred stocks in your portfolio, but if they were all tech stocks, that wasn't much help in 2001.

The illogical neglect of asset allocation by most investors is probably due to the popularity of stock picking as a national hobby. The entrancement with stock picking is re-inforced by the media, since it's a lot easier to sell magazines with articles like "Ten Stocks to Own Now!" than "What Proportion of Your Portfolio Should be Devoted to Foreign Small Caps?".

The brokerage industry, meanwhile, encourages investors to pick stocks. Stock brokers like individual stocks because they are traded more than instruments that track entire asset classes, and thus generate higher commissions. Brokers also benefit from investors' neglect of asset allocation by providing advice about portfolio rebalancing, which is more complex if the portfolio contains individual stocks than, say, index funds that track broad asset classes. And even if the customer doesn't need advice, individual stocks can move between asset classes due to changes in market cap, so individual stocks intrinsically generate more trading commissions.

So if your portfolio contains individual stocks, ask yourself whether stock picking has distracted you from diversification and asset allocation. My guess is it has.

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