Search for Winning Stocks May Cause Investors to Lose the Game

For much of the 20th century, most individual stock market investors believed that successful investing depends on buying stock in great companies.

web-axstj-stocktarget-stj3-1013-6045.jpgAnd, in fact, for many years, it worked. I have observed the longer someone (or their family) has been wealthy, the more likely they are to rely on this “blue chip” approach to investing – either by picking stocks themselves or by hiring a money manager to do so for them.

I have also observed, however, that when people are focused on finding high performing individual companies, they often overlook another set of tactics that has been at least as valuable – possibly more so.

Asset allocation tactics, many grounded in Nobel Prize-winning research about financial markets, have been used successfully for many years by sophisticated institutional investors (pension fund and endowment manager, etc.), as well as a growing number of individual investors.

Such investors do not focus first on screening the financial records of individual companies or applying Peter Lynch’s advice that investors acquire well-known companies providing high quality goods and services in the marketplace.

Rather, they begin by evaluating how much of a portfolio to allocate to different classes of investments, including not only growth-oriented blue chip companies, but also small companies, international companies and even unevenly performing “value” companies. Only after making this crucial allocation decision do such investors then go about deciding which stocks and mutual funds to buy.

Recent years have provided a great example of the value of the “asset allocation” approach to designing stock portfolios. While blue chip U.S. stock indexes like the S&P 500 and Dow Jones Industrial Average are worth less today than they were five years ago, indexes of mid-sized, small, international and value stocks have risen, some substantially.

Of course, there have been periods, like the late 1990s, when leading blue chip growth stocks outperformed these other classes. However, rigorous research has shown over the long term, investors can reduce the overall volatility of their portfolios and increase return by spreading investments across multiple asset classes. One reason for this is these niche categories of investments do not always perform the same way that growth-oriented blue chip stocks do.

Applying the asset allocation tactic to stock investing is not difficult. Indeed, most 401(k) plans give relatively unsophisticated investors the ability to allocate their investments across mutual funds investing in niche parts of the global stock market.

Nor does thinking first about how to allocate investments across companies of varying different sizes, nationalities and performance histories mean there is no place for stock picking. Though some commentators argue there is no point in trying to pick winning stocks, many professionals believe in applying both tactics.

For instance, the covers of leading financial magazines, like Money magazine, often emphasize the importance of knowing about the latest “hot” stocks. Though these magazines contain articles emphasizing the value of allocating investments across different styles, the editors know many readers are more drawn to reading about individual companies than they are to learning about allocating investments across different categories of investments.

Similarly, the popular media devotes more attention to high profile stock-pickers like Peter Lynch and Warren Buffet than it does to academics or other people who argue that it is at least as (if not more) important to pick the right stock asset classes as it is to pick the right companies.

But we should not blame the media for causing investors to focus on the search for winning blue chip growth stocks. In my opinion, media merely reflect the bias that most of us already have in that direction. It simply is human nature to be more interested in stories about individual companies that it is broad classes of investments.

For example, even though the international emerging markets were on a tear last year (for instance, Vanguard’s emerging market index was up 29 percent) I doubt my clients have talked to their buddies about that high performing part of their portfolios. But, when their Cisco stock, steered by Charleston-raised John Chambers, was sky-rocketing in the late 1990s – that was something people wanted to talk about.

There’s no denying that it is more fun to talk about and trade individual stocks than general classes of stocks. But most people don’t invest in stocks to have fun. Investors who focus only on picking blue chip growth stocks and ignore the benefits of allocating their investments across multiple asset classes are missing a powerful investment tool that can improve the long-term performance of their investment portfolios.