There's an ongoing debate of whether or not picking stocks adds value to a client's account. Here are two reasons you shouldn't.
1) A fundamental flaw
The fundamentals are the key numbers of a company that indicate how healthy it is. Many analysts select stocks based on these figures, which are derived from the company's formal financial statements.
As a Certified General Accountant who joined this industry in 1988, I was naturally attracted to this way of thinking. But a year into my career, I realized that fundamental analysis was incorrect.
Why? It started when Chrysler reported of record profits in 1989. Many baby boomers remember that the U.S. government had to prop up Chrysler in 1979. It was on the verge of bankruptcy and the government guaranteed loans for the company. By 1988, Chrysler had more than recovered from its troubles and paid off its loans.
In 1989, Chrysler stock was at all‐time highs when, on the day it announced record earnings, the stock price fell dramatically.
According to the fundamental approach, that's not supposed to happen. Stock prices are supposed to rise when record earnings are announced because that is when the fundamentals of a company are healthiest.
Seeing my puzzlement, a senior advisor asked me a simple question: How does information about a company get into the stock market?
My answer was through financial reports. He pointed out that most recent financial reports are, in fact, not current. It takes about two to three months to complete these statements for the latest quarter, so reports actually show what happened three-to-five months ago.
Non‐financial-statement sources are constantly leaking more current information into the stock market. For example, when an auto company contacts its suppliers to tell them to put on a third shift because demand has picked up, the investment advisors of those suppliers learn about this and bid up the company's stock in anticipation of better earnings.
The reverse happens when that third shift comes off, which is what happened to Chrysler in 1989. Subsequent financial reports from Chrysler showed sales had turned down and the stock selling was warranted.
I have seen this pattern repeat many times with individual stocks. There is often a movement up or down, usually with large volume, and the market commentators can't associate any fundamental news with the change in the stock price. So a company will report terrible earnings and have the stock surge and vice versa.
2) Stock punishment
This arises when earnings on a stock don't meet expectations and the price drops disproportionately. A recent high-profile example was Google on January 20, 2012. The company reported earnings slightly less than expected but the stock fell 11 %, which was disproportionate to the earnings difference.
The stock recovered some months later and went on to all‐time highs. This has happened with many other companies over the years.
Major price movements one way or the other often indicate informal, pertinent information moving into a market — but not always. A stock can get punished simply because of fear there's more to the story than investors know.
This means investing in individual stocks attracts increased volatility in a client's account. Is this worth it?
And according to Modern Portfolio Theory, 96% of clients' returns are attributed to asset allocation. The traditional diversification method of asset allocation, geographic diversification, and diversification by market cap and sector lower a client's risk, but adding individual stocks actually increases risk.
Based on this, you may want to consider stopping at the sector level and leaving stock picking out of your offering.