Courtesy of ‘dan’, a commenter Early Retirement Now, I learned this week that “buying individual stocks” is …

Only for rubes.

For some reason, my brain remembered this phrase as “chuds” instead of “rubes,” but either word works exceptionally well here. Chud, in particular, is a fantastic term. It has some onomatopoeia to it, as if one was asked, “What sound would this ugly, fat person make if he was dropped out of a tube of chocolate from a height of 10 feet?”

I’m an unabashed stock picker. My portfolio consists of 100% hand-selected stocks, and we’re talking about close to a million bucks, not some small-fry $1,000 selection here and there.

I don’t own a single index or mutual fund.

Am I stupid? Let’s find out!

Preface: most people should buy and hold index funds

Generally, you should buy and hold index funds. This article is an explanation and defense of investors who choose a different strategy. I am not advocating that ANY ONE go out and buy individual stocks.

I’m explaining how I invest and why I choose this approach over the standard advice to index. Plenty of investors follow a similar strategy, and this article is, in some ways, a shout-out to them.

Check out our investing principles here!

A litmus test for stock picking

Quick test: you have $100,000 and must pick one of two stocks to hold for 30 years: Tesla or Pepsi?

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If you picked Tesla, stop reading here. Go index, or else start educating yourself and don’t buy an individual stock until you’ve spend 5,000 hours reading Jeremy Siegel, Charlie Munger, Philip A. Fisher, and Joshua Kennon. This is an incredibly easy decision, and it’s not even close. It’s equivalent to seeing Robert De Niro sitting next to Danny DeVito and being asked: “Real quick, who will look better in a couple decades?”

Tesla stock = Danny DeVito

Funds vs. Individual Stocks: It’s all the same when you drill down

Show me an investor’s historical buy/sell orders, and I can tell you a lot about that person. As investors, we all have such a ledger, though it’s often obfuscated behind layers of abstraction. If you put $1000 into SPY today, you are buying:

  • $41.11 of AAPL
  • $32.86 of MSFT
  • $28.75 of AMZN
  • $19.42 of FB
  • $15.92 of JPM

etc…

To feel some level of extra safety because you “index” is to delude oneself. You’re still buying individual stocks, just a bunch at a time, and some of them quite unsavory.

Side note: the modern linguistics of ‘to index’ as a verb are curious. Its transitive usage has fallen out of favor, except maybe among database analysts, and yet that definition is still listed as #1. Instead, the colloquial usage of ‘to index’ today means “to buy a fund of stocks, generally selected by a weighting formula, e.g. by market cap” In Merriam-Webster, you don’t even see the words ‘stock’ or ‘fund’ or ‘invest’ in their definitions. The rapid evolution of the language here is indicative of herd mentality to me. In the personal finance community, we can shorthand a sentence like “Just index.” And everyone knows what you mean, and most people nod in agreement.

Do you sleep well with your investments?

I invest for a 50-year horizon, and I’m conservative. I wouldn’t sleep well with:

  • 14.166% of my portfolio in Financial companies
  • 26.152% of my portfolio in Information Technology companies

Combined, over 40% of my wealth would be concentrated in Finance and Tech if I held SPY.

For a portfolio designed to last 50 years, holding that weighting would be batshit insane. Here’s why:

  • Financial companies have a tendency to self-destruct every decade or two in the natural ebb and flow of capitalism. It would take some serious cajones to “hold tight” to Fin+Tech during 2008. Banks were straight up collapsing, and no one knew who was next in the line of dominoes. The game only stopped when the United States Government stepped in to provide backing to the entire financial sector. I couldn’t do it, and I can’t/won’t subject my future self to that kind of stress. Does the current administration have a modern day Timothy Geithner? Do you even recognize that name? He may have single-handedly saved the entire world economy a few years back.
  • Information technology is, hands-down, the most creative/destructive sector in which to invest. The sector grows fast, but as Jeremy Siegel points out in The Future for Investors, “For the long-term investor, the strategy of seeking out the fastest-growing sector is misguided. (51)” Growth does not equal return, as the fall of firms like Blackberry can outweigh the rise of Microsoft.

When housing prices around me dropped 10% month-over-month, my local Wachovia branch shuttered suddenly, “sell stocks” skyrocketed to a 100 reading on Google Trends:  the phrases on the tips of everyone’s tongues were “The Market,” “The Dow,” “The S&P500,” “Stocks,” “Banks,” “Housing” – I didn’t hear a single person mention Diageo, Hershey, Johnson & Johnson, Nike, or Coca Cola. Yet I saw people buying alcohol (more than usual), chocolate bars, medicine, shoes, and soda. The psychological mere-exposure effect is profound.

“Sell stocks” was a popular term during 2008’s -25% drop in SPY and again during a quick/brief -10% drop in early 2018. Sell when the market drops and buy when it rises? That makes no sense.

A note about this chart: see that big spike over in February 2018 for “sell stocks”? That happened with a quick 10.1% peak-to-trough drop in SPY. From its height in September 2008 to its low in October 2008, SPY moved -24.34%. Any predictions for what “sell stocks” trends would look like today if SPY dropped ~25% in 60 days?

I see three factors that lead to this February 2018 “sell stocks” search spike (on a modest 10% drop) being especially high:

  • More people are searching now, for everything.
  • Although modest in its size, the dropoff was especially quick and induced a lot of fear. The amount of money at stake is at an all-time high. People are jittery right now.
  • We live in a social media age. 2008 was not a social media age.

Investing: Behavior vs Modeling

I think that these two questions are fundamentally different:

  • Define the optimal model of investing for a group of people.
  • Define the optimal model of investing for an individual.

Individuals tend to lag the performance of investment models because of their behavior. Investors deviate from their investment plan based on current conditions. Their behavior is strongly influenced by mental models and psychological ticks.

Know thyself.

I know how I respond when Kraft Heinz drops 42% because it just friggin happened. I started buying in the low $70’s (fair value) and am still buying to this day (good value in the $60’s, great in the $50’s). It’s one of the world’s most dominant firms in an industry ripe for conservative investment, and the M&A approval for AT&T just cleared the way for more industry vertical consolidation, the core aptitude of 3G and KHC management. People will still be buying ketchup in 2050, and KHC will still be selling it for profit. I’ll be taking my due slice of EPS then just as I am now.

How would you respond, dear index investor, if SPY dropped 42%? Please note that the general public is not panicking about Kraft’s supposed demise, but if the overall market dropped this far, what would your conversation with your hairstylist be about? How would it influence your buy/sell orders? Did you experience 1999 or 2008 and have background data for your guestimations of your behavior?

Investor behavior and psychology

Chris and I recently discussed the lollapalooza effect of rapid technological and social changes. He asked me, “Sheesh. What’s the world gonna look like in 5 or 10 years?

I replied, “I have no clue. But I do know McCormick & Schmidt will be selling spices for profit in 10 years.”

Investor behavior on the Buy side

On the Buy side, it is incredibly difficult for a value-oriented investor to execute a Buy order on SPY right now. SPY looks expensive, full stop.

However, that same investor may look at Johnson & Johnson and decide that the valuation is reasonable in the $120-$130 range.

Would that investor be better off in cash because he’s afraid of buying SPY at all-time highs when leverage is maxed, subprime ARM’s are making a comeback, and there is a potential crisis in leadership brewing at the same time as financial and geopolitical jitters are echoing throughout the system?

Or would that investor be better off executing a buy order on JNJ at $125 because he’s confident that Band-Aids™ will still be sold a decade down the road, even if all of the scary events in the previous paragraph happen simultaneously?

Buying some abstract “The Market” versus buying a specific company, with a specific debt profile, product mix, and multiple $1B+ brands – that’s the type of decision we’re considering here. The decisions are not comprised of some optimal, formula-based model that a financial analyst can determine for a group of people: “This method is better.” Investment choices come down to the exact Buy and Sell orders that an investor executes:

Actual Behavior versus Theoretical Model

Investor behavior on the Sell side

Back to investing psychology: the mere-exposure effect, combined with social proof, is what spurred a 70-year old relative of mine to call her financial advisor no less than ten times in a week during October 2008. On the tenth time, despite her advisor’s adamant protests, my relative gave the final order to sell all of her stocks. All of them. She sold all her funds in October 2008!!!

From fear, from exposure to TV news, and from social proof – she made the worst possible investment decision at the worst possible time. She was a thoroughbred fund investor, but this approach to investing didn’t help in her time of mental peril. Had she instead focused on the number of bottles of Crowne Royal that she was drinking while she clutched shares of Diageo, she might’ve made a better decision.

Key advantage of individual stock investors: avoid dumb investments

It’s dumb to buy a cruise line operator or a shipping company. Why? Capital investments and lack of a competitive advantage.

If you have a massive, $2B MSC Cargomaster of the Seas ship, which gets 0.004 mpg moving cargo from a supplier to a port of high demand, you have a great business.

However, a rival shipping company that buys the latest and greatest $2.5B Cargosupermaster of the High Seas, which gets .0055 mpg will steal your orders, and your business has just sunk to the bottom of the sea! To add insult to injury, your already-depreciating asset also dropped in value significantly.

Investing in cargo shipping is stupid: high capital requirements and low competitive advantage. (Side note: at the right price, obviously, it makes sense. Figuring out that price is too hard, easy to move on to better business models.)

Now look at another part of the same shipping industry: rail. No one is laying new rail alongside Norfolk Southern’ 26,300-mile US East Coast network. To lay ownership claim to rights of way and rights of trackage along the greatest consumer corridor in the world: that is a MASSIVE competitive advantage.

Investing in rail is smart. Investing in nautical shipping is stupid. An individual investor can tilt toward the former and avoid the latter.

When you’re investing for decades, some categories can be easily divided into smart and stupid investments.

Smart:

  • Food/drink
  • Healthcare
  • Energy

Stupid:

  • Mining
  • Banking
  • Technology

“Stock pickers” as we’re disparaged aren’t out here searching for the company with the latest and greatest cruise ship, and we’re not scouring tech IPO’s to find the next AAPL or FB, and we’re not flipping back and forth between NFLX, TSLA, TWTR, or whatever the flavor of the week happens to be.

We’re finding the world’s greatest businesses, acquiring ownership stakes, and holding on to our shares for decades.