Stock picking and evidence-based investing represent two very different approaches to investing. Which way is best for you? Let’s look at the difference, some details, the risks, and the benefits of both.
First, Consider This...
To truly identify the core of each style of investing, we must first understand the difference between passive and active investing management strategies.
Passive investing involves tracking a market index and buying a portfolio that mirrors the components of the index. Active investing, on the other hand, involves the investor actively selecting investments with the goal of outperforming the market.
Passive investing is generally considered to be lower cost and lower risk, while active investing may have higher costs and definitely involves more risk. Passive investing could be considered a "hands off" strategy based on the long-term strategy it typically embraces.
Active investing can be time-consuming as the investor attempts to be more tactical, making regular changes to accommodate market conditions in a never-ending battle to "beat the market."
Stock Picking vs. Evidence-Based Investing
Stock picking is a form of active management. Stock pickers attempt to outperform the market by selecting individual stocks. Investors use a combination of research tools, detailed analysis, and yes, even speculation, to hopefully identify undervalued or overvalued stocks.
This often involves predicting future events, company performance, and market trends. Stock pickers often try to time the market, buying when they believe a stock is underpriced with hope of selling at a profit.
There are unlimited methods and theories to help "predict" when to buy and sell, however no matter how much logic goes into them, they are still based on an educated guess and a bit of speculation.
Stock picking can be time-consuming when you consider the ongoing research, analysis, and monitoring of individual companies, sectors, markets, trends, and economic events that need to be evaluated just to make a buy or sell decision.
Evidence-based investing relies on passive management strategies. Rather than selecting individual stocks, evidence-based investors prefer to own the broad market indices, diversified portfolios that represent entire markets, and even segments of markets.
The investment decisions are data driven, and based on empirical research and evidence from decades of studies, rather than trying to predict short-term price movements or specific company outcomes.
Evidence-based does not consider market timing and short-term speculation when planning out investments. Instead, it is grounded in holding portfolios for long term, and maintaining diversification to capture market returns and minimizing risk. Evidence-based investing can be considered "time in the market" rather than "timing the market."
What Risk?
Stock picking is inherently riskier because it typically concentrates investments within a small number of stocks. If a chosen stock underperforms or a sector faces unexpected challenges, losses can be significant.
In theory, stock pickers can generate high returns by identifying individual stocks that outperform the market. The hard truth is the majority of stock pickers underperform the market over the long term.
Studies show it’s difficult to consistently beat the market over time due to market efficiency, transaction costs, and behavioral biases.
Evidence-based investing emphasizes diversification, which reduces the risk of losing large sums due to the poor performance of individual stocks or over-saturated sectors.
A diversified portfolio spreads risk across hundreds, or even thousands, of stocks and bonds using low-cost mutual funds and exchange traded funds. While evidence-based may not generate the huge returns that a successful stock pick can in the short-term, it has a strong track record of providing steady, market-matching returns over the long-term.
"The proof is in the pudding" when considering results over the long-term.
Picking Stocks Can Be Taxing!
With stock picking, taxes are always a major consideration. The frequent buying and selling of stocks can trigger short-term capital gains taxes, which are typically higher than long-term capital gains taxes.
Evidence-based investing sticks with a buy-and-hold approach that minimizes turnover. This leads to fewer taxable events, and Investors benefit from lower tax liabilities and greater compounding over time.
It's Getting Emotional!
With stock picking, most investors will base decisions on emotions and how they feel about the markets, etc. Investors making emotional decisions to buy or sell based on fear or greed will almost always lead to suboptimal outcomes.
Don't let overconfidence sneak in! In many cases, stock pickers overestimate their ability to pick winners, which leads to higher trading frequency and lower returns.
In 1999, there was a study called the Dunning-Kruger effect that details this overconfidence perfectly. The study was based on a cognitive bias that occurs when people with limited knowledge overestimate their actual ability.
It exposes a lack of self awareness some can experience when making investment decisions. It’s also often difficult to determine whether a stock picker’s success is due to skill or luck.
No matter how they advertise it, very few active money managers outperform the market consistently when you look at performance over longer time periods.
Evidence-based investors avoid emotional decision-making by following a disciplined, data-driven strategy. Decisions are guided by long-term goals, not short-term market fluctuations.
Investors are encouraged to think long-term, sticking with their strategy through market volatility. This reduces the risk of emotional reactions like panic selling or chasing trends.
Relying on research and diversification in evidence-based investing helps investors avoid common behavioral pitfalls, such as selling low and buying high. Oops! Again, it's all about "time in the market."
Beware of Shiny Objects
Stock picking offers the potential for high returns but comes with significant risks, potentially higher costs, and a historically low probability of long-term success.
Those high return risks can come with a price! Sure, stock picking sounds exciting, but is the risk really worth it when considering your long-term wealth? Evidence-based investing prioritizes a diversified, low-cost, long-term approach based on historical research, providing a more reliable and consistent way to build wealth over time.
Stock picking is "sexy" and it appeals to those seeking the thrill of performance, however evidence-based is ideal for investors who value a stable, data-driven strategy with lower risks.
So go ahead, put a few bucks into some stocks because it’s fun, but put your real money to work in a diversified evidence-based strategy so you can sleep at night.
