While stocks do tend to move together a lot, and most investors seek to spread their money out among a wide variety of stocks, stock picking is becoming even more important.
There is something about being selective about choosing investments that turns off the great majority of investors. While it is natural to be intimidated when we contemplate something that we really have not explored doing very much, there is also a tendency to overcomplicate things when we do, and this certainly applies to the task of stock selection.
Picking stocks or sectors really should be quite a simple task when we’re just looking to do this broadly, not sweating the small stuff, not worrying about being optimal, not getting concerned about one choice ending up being a little better than another, but just looking to get on the right side of things mostly.
That sums up what should be the goal at the level of the individual investor very well, just seeking to mostly be on the right side. If you are investing in a certain type of stocks, a certain sector, and that sector is significantly underperforming, and we hold them anyway, this is where we really miss the boat, as well as missing out on much bigger moves in other sectors that we have gone light with or even avoided.
It’s all too easy to just invest in a broad index such as the S&P 500, and the allure of this is attracting more and more investors all the time. There is a huge market for something like this, and for most, they may want to stick with such a plan if the amount of effort and thinking that they are willing to engage in lies at zero or is very minimal.
These investors see the decision between passive and active investing as involving some sort of great divide, much like considering putting your 6-year-old kid in university, where they will be completely lost and overwhelmed. You can get started in active portfolio management right at grade 1 though, but only if you enroll.
The university is still there, the real advanced stuff, the sort of thing that investors see as far too complicated for their interests, experience, and abilities, but you don’t worry about what they are teaching in university when you are 6 years old, you instead look to start very small and master the very basics.
Not bothering attending school at all might see yourself get by decently, but if you want to make your way in life and give yourself a good opportunity to succeed, shunning education entirely isn’t the best way to achieve this. If there are some simple lessons out there that we can easily learn and employ, and these lessons can help us, knowing how to make some basic decisions such as actually paying attention to the making of money and doing it safely enough that investing is all about, this can really help you get ahead and achieve your goals more.
If we think of index investing as day care, where all they really teach you is to behave and not to think, at least some investors, those with a desire to do better but without the education to make this happen, might consider enrolling in grade 1, breaking down their index into sectors and viewing things from that perspective instead.
We probably don’t want to throw these kids into higher grades, the ones involving deciding at the level of individual stocks, even though this task can be made far easier than the kids think that it is with the right approach. There are 500 stocks in the S&P 500, and we can just watch them all just based upon performance, where all we do is look at their performance lately and look to be in the good ones mostly and out of the poor ones mostly.
There’s more to do with a strategy like this, and this is material learned in a higher grade, not the grade one that we need to start at. We might even not want to ever graduate to grade two, but we should be starting school in grade one, breaking this index into the 10 sectors that have been conveniently put together for us with what are called SPDR sector ETFs.
Since stocks are not commodities, they do differ in the categories that we are concerned with as investors, potential return and risk. Since this is only grade 1, we don’t really need to be worrying about managing risk all that much, even though this is important. This will be taught more in the higher grades, and again, we may not even choose to move up to grade two, and a grade 1 education is miles ahead of just playing with toys in a nursery setting.
Investors who attend play school where all they do is show up every day and there are no grades handed out, and all you need to do is be nice to get along fine, have been doing decently well, but if you are not educated, you won’t know what you are missing out on, and this exactly describes the perspective of these students. A lot of kids don’t like school, they dislike being challenged, but there is a lot more on the line with this, with our financial well-being directly on the line here and not tangentially like with regular school.
If you can’t manage 10 potential positions, and we don’t want to be in all 10 because that puts right back into the play room, you aren’t going to be able to handle 500 or more. The right way to do this is to start slow and work your way up, and while there is much more to learn if you are willing, you can worry about that when you get there, when you are more ready.
Just like in real school, there will be some students who have a higher aptitude than others, who are smarter than others, who have more discipline and commitment than others, but just going to class, and this one in particular, will convey some real potential benefits that all can enjoy.
While it might be entertaining enough to throw Lego pieces at one another, when we come to realize that we can assemble these pieces and build things, this is where our education begins. This is what our grade one education seeks to teach us.
This Can All Be Made Very Simple if We Choose To
The concept here is a simple one. We take the S&P 500 that the toddlers play with, and break it up in such a way that can allow us to differentiate and choose the better pieces and discard the poorer ones. This is not unlike our being given tiles that have a number on it, and knowing which numbers are higher or lower than others, we pick the bigger ones and toss the lower ones.
While this is a bit of an over-simplification as far as sector selection goes, at the entry level, in grade one, it’s actually pretty close to what we actually do. The problems that we run into doing this is to try to make the task more complicated or much more complicated than it needs to be. This really is about picking bigger numbers, and if you have learned that lesson, you are ready to start using this skill.
We have to cover a little theory first before we put this into practice, why we should be differentiating between stocks in general and why doing this by sector makes sense. Stock prices generally go up over the long run, and we could just buy them all and make money that way, but we want to make more, as we should want to do.
From the entire basket of stocks, we select various combinations that involves some sort of refinement to seek to achieve better performance. This makes perfect sense, because there are always going to be certain types of stocks that perform better than other types. Baskets of stocks then become grouped together, called in index, which we can buy shares in and not have to make any decisions at all.
There are two main decisions that we make when we invest in stocks, which are what stocks to hold and how long to hold them for. We can explain this in terms of our entries and our exits, where entries determine only what to buy but when. Exits are also about when, but also involve what and when to enter if we wish to substitute the choice. We might exit a position not because it’s not generating profit, but because there is another opportunity that is clearly better, and we may then choose to put our money in that instead.
This is where differentiation comes in, and we have to separate performance with one particular type of stock over another to be able to measure this and decide. We’re not picking our own stocks at this level, but we are picking between baskets of stocks, and all baskets involve some sort of refinement, as these indexes don’t just pick their components at random and that would make no sense, with our profit expectations being the same as holding all stocks but in a way that is more volatile.
The S&P 500 is a pre-selection of 500 stocks that have been picked over the years based upon their being big stocks, large cap as they call them, as well as their showing that they can perform minimally well. The stocks aren’t just picked for this, they need to maintain these standards and they get removed when they don’t.
Indexes don’t want to do too much of this because the tracking of these indexes are also used to take the pulse of the market. If you looked at a chart of the index over time and wanted to know the path the stocks in them have taken, ideally, they would be the same stocks. If they changed a lot, what is being measured would differ so much that you’d be tracking the skill level of the people selecting them, how well they did with changing the index’s components. Stocks have to do very badly indeed to get the boot from an index like the S&P 500, but some do.
An index like this does differentiate somewhat, but doesn’t do very much at all. Our advantage over a random selection requires enough differentiation, although within this bigger index, there are 10 smaller ones that represent various sectors.
This separation makes sense because stocks in a given sector behave more similarly than stocks in different sectors. Understanding how stocks work at their most basic level is easy enough for even grade 1 students to grasp, and all you need to realize is that the more a stock is liked by the market, the better it does, and vice versa.
People love to make this a lot more complicated, which essentially involve looking into why people put more or less into stocks. Following the money, just watching the price of stocks and indexes change over time, is plenty enough and will put you well ahead of the pack, those who think that they can study these things fiercely and believe this will allow them to understand things better.
It’s not that these additional insights aside from paying attention to price changes can’t be useful, but not if we allow these things to supersede the end values, where all influences on stock prices converge into the price itself. This needs to be the baseline where we may or may not refine it but we can’t throw it out, as we see with those who think their beliefs should guide these things, like thinking a stock is worth a certain amount even though the people disagree, which just serves to lead us astray.
The people decide how stocks do, how much money they put into them in general and how much they put into each stock. Another trend, and one that we’re really seeing build more and more, is investors being more selective in what they invest in and gravitate more toward the better performers and away from the lesser ones.
As this trend increases, and it has really increased lately, where more and more folks are investing based upon performance, this causes the good stocks to go up more and the poorer ones to underperform more. You could see the big index run flat but have the better stocks go up pretty well, and this is happening more and more these days, making selection more and more important.
The Gap Between Good and Bad Stocks Continues to Widen
The trend here has been manifesting over the longer-term for decades now, the shift from basing selections on what is called the reversion to the mean strategy to one based upon momentum. There was a time where investors used to see lagging performance as an opportunity, thinking that it will make up some of this ground, and worried more about stocks that had done well, thinking that the more a stock up, the less likely it is that it will go up further, and the more it goes down, the more likely it will go up.
If everyone believed this, this could happen, because once a stock went up, demand would decline, and when prices dropped, demand would increase. If we imagine two stocks, A and B, if investors see stock A going up and stock B going down, and they sell A and buy B, this is going to reverse the trend.
The reversion to the mean strategy doesn’t align that well with reality though, and particularly isn’t aligned with what happens with companies. Company A has done better and their stock price is higher. Company B has struggled and people buy more of what company A sells and less of what they sell, and the difference between them as the advantage increases over time tells us that company A should be worth more and more.
While the reversion to the mean strategy still lives, investors have seen its limitations more and more, and moved away from it more and more. You start with a lot of people in a tug of war, and although their side starts weaker, and they may only lose a bit of ground at first, as more and more people give up on this, the advantage of the other side increases.
This other side is the belief that the price of a stock going up makes it more likely for it to go up further than one that is going down. While there are situations where we may have oversold stocks to where they will need to go up to reach their longer-term value, like in the case of Disney which we spoke about yesterday, you really need to confine yourself to situations where things are expected to improve notably, as is the case with this stock, before buying depressed stocks makes much sense.
The natural force here, given that company performance affects the demand for its stock, is that better stocks will tend to be more likely to continue this outperformance than not. The company’s results and prospects are better, and it’s more likely that they will continue to enjoy this advantage over competitors that are behind and are more likely to fall further behind.
This is also the case with sectors, where the technology sector has been beating the energy sector for quite a while now and the gap has widened over this time. This gap could narrow one day, but as long as it continues, as long as it has momentum, we’re better off being on the right side of this momentum than on the wrong side.
At certain times, it can make the most sense to have all of your money in just one of these 10 sectors, as being the top performing sector means that it is superior to all of the rest. The problem here is that nothing is certain with investing, and we don’t know for sure that the top sector will continue this, much like a horserace where other horses overtake the lead horse even though it’s more likely than not the lead horse may win.
Our horse may have the best odds and we may want to put all of our money on it, but we also may want to hedge our bets and bet on one or more other ones that we also like. Things change, especially macro events like recessions or trade wars, or quarantines over pandemics, can alter the outlook for our selected sector or sectors and lessen the positive conditions that we based our choice on.
The less number we choose, the higher the risk is that our positive expectation may change, where choosing two sectors will reduce our expectation for now but protect against something happening to the top sector.
Many understand this concept, but what gets missed with looking at sector risk is the importance of taking the performance gap between sectors into account. If there were four choices, and we are considering either going with the top one or the top two, the top one may outperform the rest to the extent that the cost of diluting this advantage just isn’t justified.
Deciding how many of the 10 we want to hold therefore comes down to seeking the right balance, and since we’re looking to greatly simplify this in the way that index investors seek and love, where these investors won’t be monitoring change that closely, this will require a broader selection than if you were managing the positions actively. To do this, we may want to look at more than one sector to be in.
We’re now going to look at the performance of these 10 sectors over the last 2 years to give us a feel of who is hot and who is not, and by how much. The S&P 500 is up 6% over this time, with 5 sectors above this line and 5 below.
Energy is down 51%, and even while it may have been beaten down a little more than some think it deserves, this is a sector in free fall and has performed terribly over the last 5 years at the best of times. When you buy the S&P 500, you buy all 10 of these, including one this toxic. We not only want to discard the energy sector, we want to dispose of it in a protective bag.
Financials come in 9th place with a loss of 22%, and this has become a troubled sector now where risk has shot up a lot. Neither Industrials (-16) or Materials (-13) have been in favor for quite a while, and both have stunk it up over the last 2 years as well.
Financials looked decent enough until this crisis that we’re now in hit, and this is an excellent example of sector risk rearing its ugly head, and why this game doesn’t just involve playing a hand at the start and putting the deck away, and requires that we also reassess things periodically.
This requires that we not only check under the hood to get these numbers but to also pay attention to the weather, and when we see dark clouds over a sector, we should not be ignoring such things.
The next three have all shown positive results over this time, although at best beating the average by only a couple of percent at best. While the bottom four distinguish themselves as being terrible right now, mediocre isn’t desirable as well, as what we’re out to do here is create diversity but also seek to beat this index.
Consumer Discretionary (8%) and Utilities (7%) only offer us a bit over the big index’s 6%, and Real Estate (4%) haven’t even kept up. If the top 3 didn’t stand out enough, and the gap between them and Consumer Discretionary was small, we might want to include this, but that’s not the case.
Consumer Staples has delivered 14%, over twice as good as the market, and considerably higher than 8%. Given that Technology (35%) and Health Care (22%) have both beaten this considerably, and given that these are two sectors that are expected to continue to grow, with the growth of staples being more limited, we have our two winners.
We could have picked them even without looking at any numbers, but we want to make sure that our beliefs are reflected by performance, and the beliefs that do not are certainly not worth having. When the outlook and performance align, that’s where we need to be.
There’s been no denying the power of technology stocks, but we also want a piece of the health care sector, especially during these times. This is a nice combination right now, sectors that can thrive both in normal times and even during distressed ones such as now, and those who feared that this was the wrong place to be when the bears come have been shown differently.
You can drill down from here to either go after sub-indexes of these sectors or even put together your own basket of stocks where you can look to build more of an all-star team as well as further weed out the chaff that is in all indexes. We need to ensure that we are staying within our abilities though, and while it doesn’t take much more learning to get to this level, we should not be skipping lessons and just pick a bunch of stocks without thinking about what we are trying to do here enough.
These two sectors are a nice choice for those looking to play the SPDRs, and while many would generally want to mix in a lot more, we need to make sure that it’s worth throwing in a lesser one right now. Whatever we choose, even eliminating the ones well in the negative will make a big difference.
Investing should never be a one and done thing, and this is a strategy that requires us to pay attention and to revisit our choices from time to time. We need to not only keep an eye on our sectors, but on the others as well, to ensure that if better choices are out there, we are aware of them. Choosing can easily beat the non-choosing of index funds, but particularly if we choose well.