There are investment services like Pure Financial Advisors that reject stock picking and market timing. Instead they view asset allocation as the prime determinant of returns. Believing in the importance of investment research, they champion factor-based strategies. On the other end of the spectrum there are firms like First Pacific Advisors (Trades, Portfolio) who believe in value investing, stock picking and market timing. The disparity of approaches shows how difficult it is to say whether it is asset allocation that really matters or stock picking.
Asset allocation
I like to be right. I try not to miss the big ideas, forget the little ones and try to get them right. End of job description.
Thinking about asset allocation can’t be avoided. The mere fact there are multiple asset classes and you can get exposure to radically different return profiles is a free lunch that’s hard to turn down.
If you are measuring very long time spans or you take extreme approaches, then asset allocation is going to have a profound effect on your returns.
Just think what happens when you put your savings in two-year Treasuries and roll them over for half a century. You’ll be essentially standing still given inflation. The difference in returns between 62% stocks and 38% bonds versus 60% stocks and 40% bonds is nowhere near as profound.
Another benefit of spending time on asset allocation is that as you learn about different asset classes, it may open up opportunities in the micro economy you otherwise would not have identified.
If you are spending a tremendous amount of time pondering a minor shift in asset allocation, the time may be better spent researching specific stocks.
Stock picking
"If you don’t study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards.”
-Peter Lynch
Stock picking does nothing in the aggregate. If you spent time optimizing your portfolio for the risks and returns you would like, it will likely result in a bit of extra return or less risk. However, if a stock picker is beating the market, he’s taking returns out of someone else’s returns. The baseline for a stock picker isn’t very good. It also gets exponentially more difficult as you have more assets to manage, which makes it an investment approach that doesn’t scale as well except for the truly brilliant.
If you become a tremendous stock picker or have a small amount of capital to work with (for example your own capital) it can make a huge difference. If you look at track records of the truly great investors you will notice it is very difficult to stay ahead of the 20% annualized returns.
Source: Gurufocus scoreboard
The best records almost always entail some exploitation of leverage. If you drill down on their track records you will also find that most of the greats were running circles around everyone else early on with small amounts of capital under management. As Warren Buffett (Trades, Portfolio) put it:
"I could name half a dozen people that I think can compound $1 million at 50% per year -- at least they'd have that return expectation -- if they needed it. They'd have to give that $1 million their full attention. But they couldn't compound $100 million or $1 billion at anything remotely like that rate."
On an absolute basis, investors like that are taking a bigger chunk out of aggregated returns later in their careers. But they are not achieving the same high level of yearly returns. One reason Jim Simmons is ranked so highly, and that's after charging super high fees, is because the firm manages internal capital only.
The quandary with stock picking is that if you do it casually you are highly likely to be providing the experienced stock pickers with their source of outperformance. However, you need that experience and practice to arrive at a point where you will be able to start adding value through stock picking to your portfolio. However, stock picking is not as scaleable.
Whether selecting individual stocks is your best approach mainly depends on whether you:
- Truly enjoy learning and reading about companies.
- Have an enormous amount of time you'd like to dedicate to the craft.
- Have a reasonable amount of starting capital.
- Have enough runway to compound after you get good at it.
The older you are the less sense it makes. If you are 70 and need to learn stock picking, it is not just tougher but you have less runway to put the skills you will acquire to practice.
Conclusion
Both thoughtful asset allocation and stock picking are important. Increasing your knowledge about different asset classes may have a profound effect if you run a very extreme allocation with either a lot of cash or equities only. Learning how to pick stocks isn't always the most productive way to spend your time. However, if pursued with a passion and enough runway to reap the rewards it will add more value compared to optimizing your asset allocations.
