In A Random Walk Down Wall Street, Burton Malkiel suggests owning stock indices as the best way to trade in the market. He writes, “Indexing is the strategy I most highly recommend for individuals and institutions” (402). An exchange traded fund (ETF) trades like a stock, but consists of more than one stock (i.e. a fund). For example, the SPDR S&P 500 (ticker: SPY) is an ETF that tracks the Standard & Poor’s 500-Stock Index. Malkiel highly recommends purchasing a portfolio of all companies in an index such as the S&P 500 because you avoid the challenges of identifying between winners and losers, which might actually be impossible. According to Malkiel,
The logic behind this strategy is the logic of the efficient-market hypothesis. But even if markets were not efficient, indexing would still be a very useful investment strategy. Since all the stocks in the market must be owned by someone, it follows that all the investors in the market will earn, on average, the market return. (391-192)
As a result, owning a stock index is a smart and effective way to invest in financial markets. If the efficient market hypothesis (EMH) is correct, then purchasing an index is the only sensible decision since there is no way to correctly pick winning stocks. If the EMH is not correct, then purchasing an index will still at least produce the market return.
Despite these wise words, many investors still wish to be stock pickers. According to the Wall Street Journal, “Here’s the latest evidence that stock picking is back: Investors are buying and selling fewer exchange-traded funds… The data suggests that investors are increasingly favoring trades in individual stocks”. The article suggests that investors’ preference for ETFs is dependent upon the predominance of macroeconomic headlines. When macroeconomic issues dominate the news, then the correlation among stocks increases. Macroeconomic data contributes to systematic risk, which is something that all stocks are exposed to. According to Malkiel,
Now, the important thing to realize is that systematic risk cannot be eliminated by diversification. It is precisely because all stocks move more or less in tandem (a large share of their variability is systematic) that even diversified stock portfolios are risky. (217)
When positive macroeconomic data is released, then all stocks will likely rise. When negative macroeconomic data is released, then all stocks will likely fall. As a result, investing in an ETF is an effective way to increase your exposure to systematic risk and diversify away unsystematic risk (i.e. factors particular to an individual company). And when macroeconomic issues become less prevalent, then investors would rather conduct stock picking.
Although Malkiel much prefers investing in indices, he understands that not all investors will always prefer investing in indices and offers four rules as a guide for selecting individual stocks. According to Malkiel, “Rule 1: Confine stock purchases to companies that appear able to sustain above average earnings growth for at least five years” (403). Following this rule will help investors select stocks with potential for future earnings growth. If the investor is successful, then the stock will increase earnings and the stock’s multiple might increase as well. According to Malkiel, “Rule 2: Never pay more for a stock than can reasonably be justified by a firm foundation of value” (403). Although Malkiel believes that it is impossible to calculate the exact intrinsic value of a stock, he does believe one can assess whether a stock is reasonably priced using the price-to-earnings (P/E) multiple. If a stock is trading at a P/E multiple that is significantly above the market average and the company’s growth prospects are not significantly above average, then that stock is overpriced and an investor should not but it. According to Malkiel, “Rule 3: It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air” (404). Due to the importance of psychological elements in determining stock prices, stock prices can skyrocket as investors’ expectations about future growth increase. Although predicting the expectations of investors in the future is inherently challenging, it is still a worthwhile pursuit. According to Malkiel, “Rule 4: Trade as little as possible” (404). Transaction costs such as broker fees and taxes can erode the profit from any investment strategy. In short, investors must resist the urge to trade frequently.
Although I am a strong believer in using ETFs to invest in entire indices, I also think there is a place and a time for picking individual stocks. After an investor has a well diversified portfolio, I believe an investor can take the risk and choose individual stocks. If an investor follows Malkiel’s four rules, then I think stock picking can supplement ETFs.