Monday, July 30, 2012

Thoughts on Investing from Absolute Returns

5 reasons to ignore top 10 stock lists

1. Folly of forecasting – The existence of these lists implies that the creator of the list has some ability to forecast excess returns for these securities over the next twelve months. The track record of forecasters is by all accounts terrible. Why should we expect markedly different results in this endeavor?

2. Ignoring risk- We talked a couple days ago about the importance of risk management, specifically the use of stop-loss orders for traders. Do these lists have explicit, actionable risk parameters attached to these ideas? The best case is that the list has an implicit time stop, i.e. one year, for each security.

3. Time frame mismatch – is not a fan of these lists either. Barry Ritholtz at the Big Picture writes: “I always hate these kind of stock picking cliches — and why do you have to commit to holding a stock regardless of what happens if conditions change?” In short, for many investors there is a definite mismatch in time frames.

4. Incomplete diversification – In today’s market ten securities is likely not enough to compose a diversified portfolio.
It definitely doesn’t hold if you plan to have a globally diversified portfolio.

5. Inflating the value of security selection – If nothing else the past few years have taught us the fact that security selection can take a back seat to larger economic/macro influences. The far bigger and more important decisions investors have to make have to do with risk tolerances, asset allocation, etc. Security selection is at best the last item on a financial plan.

There are undoubtedly five more reasons to ignore these lists, which would make for better symmetry. However before putting this argument to bed on why these lists can safely be ignored let’s look at one person who does stock lists right. Eddy Elfenbein at Crossing Wall Street puts out a buy list of 20 stocks every year. In which he replaces 5 names or 25%. Therefore some of the names on Eddy’s list have been on for much longer than a year. The best thing is that during the year you can get Eddy’s commentary on the stocks along the way. I don’t know if Eddy’s list is going to outperform in 2012 like it has to-date in 2011. Frankly, neither does Eddy. But at least Eddy’s approach is clear, consistent and above all replicable.

Most investors are well-served in ignoring the year-end top ten stocks for 2012 lists and focusing on things that matter more for their investing. These include rebalancing their portfolios, making sure they have optimized their taxes going into year-end, looking for ways to lower their expenses and in these tough times reassessing their tolerance for risk. Investing is too hard to think that a list of ‘top stocks’ will transform your investing results in any sort of meaningful fashion.

Steve Cook received his education in investments from Harvard, where he earned an MBA, New York University, where he did post graduate work in economics and financial analysis and the CFA Institute, where he earned the Chartered Financial Analysts designation in 1973. His 40 years of investment experience includes institutional portfolio management at Scudder, Stevens and Clark and Bear Stearns. Steve's goal at Strategic Stock Investments is to help other investors build wealth and benefit from the investing lessons he learned the hard way.