February 2016 Market of Stocks

“It’s a market of stocks, not a stock market”

– Old Wall Street saying

I think one of the causes of investor’s problems today is that they spend too much time worrying about “the stock market” and too little time studying the stocks in the stock market. In this newsletter I will discuss how using “asset allocation” to build portfolios has increased the popularity of ETFs and index funds and, unfortunately, also created an unnatural preoccupation with “the stock market.” Furthermore, ETF and index fund popularity has led to “price insensitive” investors who, if they lose money investing in over-priced stocks in ETFs or index funds, blame “the stock market.” I will defend why I believe “stock selection” is the better approach to portfolio management because it capitalizes on the fact that “It’s a market of stocks not a stock market.”

“It’s tough to make predictions, especially about the future.”

– Yogi Berra

Whether out of necessity or the fear of missing out, many people have turned to investing in “the stock market.” As such, they spend an inordinate amount of time worrying about the stock market as opposed to the stocks in the stock market. Why do they do this? I believe there are several reasons. The first is because they have been told that few can outperform “the market” so they should be content to invest broadly in a basket of stocks like an S&P500 Index fund or ETF and get the return of “the market.” If you click on the “Investing” tab of financial media websites, you will see plenty of articles predicting where “the stock market” is headed. If you agree that “the stock market” is going up, then you buy. If in your opinion it is going down, you sell. Unfortunately you only get a cursory review of the fundamental merits of any of the stocks in “the stock market.” This leaves little work for investors other than to opine about the direction of “the stock market” which is dangerous, especially if you are following the crowd. Index funds and ETFs, and now sector funds like healthcare or cyber-security have turned “investors” into “asset-allocators”, as people’s only investment job these days is to parse how OPEC or the Fed or China’s every move may affect “the stock market.” From these opinions, as opposed to basic research, they “allocate” accordingly. And since ETFs can be traded throughout the day, people can change their “allocations” as often as their opinions. Some financial planners/advisors have made a career out of continually “reallocating” people’s portfolios.

“We made too many wrong mistakes.”

– Yogi Berra

I believe having a good Investment Process is more important than getting a good Investment Outcome. Let me explain. If you are a golfer and your drive ends up in the middle of the fairway because of a good swing, that’s a good Process. If however, your drive ends up in the middle of the fairway because you have a terrible swing but luckily the ball bounced off a tree back into the middle, that’s a good Outcome but not a good Process. I’m sure you would agree that you had better head back to the practice range and improve your swing Process because you can’t count on a lucky Outcome all the time. The point is, when people worry about “the stock market,” they are worrying whether they have the right “Asset allocation.” In my opinion, this means their attention is incorrectly focused on their Outcome instead of their Process. Concentrating on the Investment Outcome over the Investment Process means you are guessing and hoping that some portfolio “diversification” will kick the ball back into the middle of the fairway. If you focus on perfecting your Investment Process you will find yourself concentrating on “stock selection” instead of “asset allocation.” If you would like a copy of our Investment Process, please call or email us.

“We’re lost but we’re making good time.”

– Yogi Berra

Concentrating on “stock selection” minimizes another problem that arises from thinking too much about “the stock market.” That is “price insensitivity.” If you indiscriminately own all 500 stocks in an S&P500 Index fund or ETF, along with a few sector specific ETFs because your “asset allocation” suggests it, you will own hundreds, if not thousands, of stocks and have a greater chance of buying over-priced ones. Blackrock’s “North American Tech-Multimedia Networking” ETF contains 26 different stocks in the tech sector alone! How does anyone stock even move the needle? Strangely, many investors don’t even know what stocks are in some of these ETFs. Many people built portfolios with “allocations” to commodity stocks irrespective of the fundamentals simply because they believed China would use up all the world’s gold, copper, oil, etc.

“In theory there is no difference between theory and practice. In practice there is.”

Yogi Berra

So is “asset allocation” totally unimportant? No. “Asset allocation” involves apportioning one’s portfolio between the three main asset classes: stocks for growth, bonds for safety first (and income second), cash for bills, emergencies, and opportunities. “Asset allocation” is important, and should be done based on one’s goals, along with their risk tolerance and time horizon. It should not be based on what return you think “the stock market” will offer one asset class over another. The problems with mortgage-backed bonds should have taught you the lesson of “allocating” for return. I believe “stock selection” is the cornerstone to achieving portfolio return. Just ask Jeff Bezos at Amazon, Bill Gates at Microsoft, or Mark Zuckerberg at Facebook about the connection between “stock selection” and returns. It has always been “a market of stocks.”

“You can observe a lot by watching.”

Yogi Berra

What are the signs investors could own over-priced stocks and be worrying too much about “the stock market?” For me, the biggest sign is when discussions with investors focus more on the fluctuations of “the stock market” and the “bottom line,” the total value of their portfolio, than on the progress of the individual stocks in their portfolio. Stocks are like family members; each progresses at its own pace regardless of what’s going on around them. A portfolio where almost everything is performing equally well at the same time is abnormal and should be concerning. A portfolio where almost everything is equally suffering is (usually) a temporary occurrence. If your Investment Process is sound, DON’T change your swing please! Tallying your net worth is part of a financial planning discussion including whether you are spending too much or saving enough. This is totally different from an investment discussion which involves assessing the merits of the investments in your portfolio.

“Life is a learning experience only if you learn.”

Yogi Berra

In summary, I believe investors spend too much time worrying about “the stock market” and too little time paying attention to the stocks in the stock market. It starts with investors’ preoccupation with the “news” which has always been around to distract and scare us. From a “big picture” standpoint, there seems to be nothing but predictions for a future of “bad news” and this bleak outlook has affected people’s opinion about “the stock market.” I believe the major reason why investors worry so much about “the stock market” is because they are told they can’t do anything about it.

They are told a majority of them cannot outperform the market so just invest in the entire market via index funds or ETFs. By definition only a minority can ever outperform! The quickest way to be in the majority that underperforms is to believe that “asset allocation” determines your return. If you spend all your time on “asset allocation” you will be concentrating on your Investment Outcome instead of Process and be continually changing your “allocations” as your opinions (and those of the crowd) change. You will become “price insensitive,” own over-priced stocks by accident and possibly lose money with them and end up perpetually worried about “the stock market.”

You can do something about this. Quit worrying about “the stock market.” Concentrate on “stock selection,” the fundamental investment merits of the stocks you own. Stocks with good fundamentals have a good chance of going up. This will help refine your Investment Process, which should cause you to own less over-priced stocks, which should result in better returns which should help you meet your goals. When asked why we don’t worry about “the stock market,” the first thing we say is that we think about “the stock market” but we don’t worry about it. More importantly, we respond that we are less concerned about “the stock market” than about the “stocks” in your portfolio. That’s because we’ve learned “It’s a market of stocks, not a stock market.”

Thoughts for Investors is a quarterly newsletter written for clients since 1997 by this author. The purpose is two-fold. First, it is meant to help explain the investment philosophy that guides the author’s approach to portfolio management. Second, it is meant to remind readers of important behavioral skills that the author believes are necessary to help them become successful investors. The author welcomes comments and criticisms, especially if they can be shared for the betterment of all investors. Quotation is permitted with full attribution.