Why Picking Individual Stocks Is a Fool's Game

It’s a gamble: sometimes you’re right, but oftentimes you’ll be wrong.

Nov 19, 2024

Investing in individual stocks is a lot like trying to guess if it’ll rain in a week based on the cloud you see today. Sure, you might get it right once in a while, but if you make a habit of it, you’ll often find yourself standing in the rain without an umbrella. Even the most brilliant minds in finance have been humbled by the market, and yet, there will always be investors who believe they can outsmart it. Why? Because the market is, at its core, just a giant casino. And in a casino, every gambler thinks they have an edge.

There’s always a flavor of the day/week/month stock or asset class. It could be Tesla, Bitcoin, or a collection of AI-driven tech companies that promise to revolutionize every industry from healthcare to agriculture. These flavors are wrapped in narratives that are seductive and, at least for a brief moment, seem undeniable. But that doesn’t make them any less speculative. The thing about individual stock picking is that, after a while, you’ll realize that most of your time is spent chasing after stories rather than profits.

The Market Is a Giant Casino

Tesla short sellers

Let’s talk about Tesla for a moment. It’s a prime example of how the market can defy logic and punish even the most informed investors. Remember when hedge funds were lining up to short Tesla? Some of the smartest, most well-credentialed investors in the world were convinced that the company was overvalued, that Elon Musk’s vision was more pipe dream than reality. These hedge funds weren’t just staffed with amateurs—they were full of MENSA candidates and Ivy League graduates, people who had spent their lives mastering the art of finance. These were people who had made fantastic investment calls in the past. And yet, they got burned.

How badly, you ask? Hedge funds shorting Tesla lost at least $5.2 billion since Donald Trump won the U.S. presidency this year.

And the thing is, these hedge fund managers didn’t lose because they were stupid. They lost because they were too smart. They had seen this story before. They had shorted overhyped companies in the past and made a killing. They had developed pattern recognition skills that had served them well for decades. And they were right—except for one small detail: this time was different.

Tesla wasn’t just another overhyped tech company. It was a cult stock with a visionary leader, a fanatical customer base, and a market that was willing to suspend disbelief. And that was enough to send the stock soaring, despite all the financial models that said it should have crashed.

Going long can be equally value-destroying

But of course, it’s not just the short-sellers who get burned. Going long on individual stocks can be just as perilous, and often in a much more painful way. After all, at least when you short a stock, you know from the start that you’re doing something risky, something contrarian, something that might get you laughed at at cocktail parties. But going long? That’s supposed to be the safe play. You’re betting on growth, on innovation, on the future. You’re betting on the inevitable march of progress.

Or at least, that’s what you tell yourself. But then you wake up one day and realize that you’ve bet on Peloton, Zoom, or Snap, and suddenly it’s not so clear that the future is going to look the way you thought it would. Remember those glory days in 2020 and 2021 when these companies were the darlings of the pandemic trade? Peloton was revolutionizing home fitness, Zoom was going to replace the office, and Snap was... well, Snap was doing whatever Snap does, but investors loved it anyway. And then? Well, and then the world changed. People went back to gyms, back to offices, and back to ignoring Snap. And the stocks, once flying high, came crashing back to earth, incinerating billions of dollars in market cap along the way.

Peloton, once valued at nearly $50 billion, is now worth a fraction of that. Zoom, after briefly being worth more than ExxonMobil, has seen its stock price tumble as its core business faces competition and the post-pandemic world has recalibrated its expectations. Snap? Well, Snap’s stock has collapsed by over 80% from its 2021 highs, wiping out tens of billions of dollars in value. These aren’t just numbers—they reflect real investor losses, real retirements delayed, real yachts not purchased. Going long on these companies wasn’t just a bet on their success; it was a bet on a future that didn’t materialize. And when that future didn’t show up, those long positions turned toxic.

The Fallacy of Pattern Matching

This brings us to the core issue with stock picking: it’s often based on pattern matching, the idea that if you’ve seen something before, you can predict what will happen next. In the world of finance, this is seductive logic. After all, financial markets do have patterns, and if you can spot them, you can get rich. Or so the thinking goes.

But here’s the problem: sometimes things really are different. The past is not always prologue, and markets have a tricky way of rewriting the rules just when you think you’ve figured them out. Tesla was different. The rise of cryptocurrencies was different. And the next big thing—whatever it is—will probably be different, too.

Even professional investors, with all their resources and experience, fall into this trap. It’s not a question of intelligence. It’s a question of conviction. Hedge funds didn’t lose billions shorting Tesla because they were dumb. They lost because they believed too strongly in their ability to recognize patterns. They had seen this story before, and they were sure they knew how it would end. They just didn’t count on Tesla rewriting the script.

The Science Behind the Gamble

If you’re still not convinced that stock picking is a fool’s game, let’s talk about the data. A study by Hendrik Bessembinder, a finance professor at Arizona State University, found that only about 4% of stocks have significantly outperformed Treasury bills over their lifetimes. Let that sink in for a moment. Out of all the stocks that have traded on U.S. markets between 1926 and 2016, only 4% accounted for nearly all of the net dollar wealth creation. The other 96%? They were, at best, mediocre investments. Many of them lost money.

So, if you’re picking individual stocks, you’re essentially betting that you’ve found one of the 4% that will outperform over the long term. That’s not investing—that’s gambling. And the odds are not in your favor. The house—just like in a real casino—almost always wins.

Yet investors still believe they can beat the odds. After all, they believe they can recognize patterns and spot opportunities that others miss. But as the Tesla short sellers and countless other examples have shown, pattern recognition isn’t enough.

The S&P 500 Problem

If you’re not convinced by the Tesla example or the Bessembinder study, let’s look at some more sobering statistics. The majority of professional fund managers—who are paid handsomely to pick stocks—failed to beat the S&P 500 in 20 of the last 23 years (87% of the time).

2009 Was the Last Year a Majority of Active Funds Beat the S&P 500 📈

So, if professionals, with all their resources and expertise, can’t consistently beat the market, what hope does the average retail investor have? The answer is: not much.

The Macro Disadvantage

Another issue with picking individual stocks is that it leaves you vulnerable to macro conditions. If you’re holding a portfolio of individual stocks, how do you prepare for a bear market? How do you hedge against inflation, rising interest rates, or geopolitical instability? The reality is that you probably don’t.

You’re too focused on picking the right companies, and you assume that if you’ve chosen well, you’ll be fine in the long run. This is the logic behind the popular investing mantra: “time in the market beats timing the market.” And while there’s some truth to that, it’s not the whole story.

The problem is that when you’re holding individual stocks, it’s psychologically difficult to make adjustments when macro conditions change. You’ve invested so much time and energy into researching and picking these stocks that it’s hard to let go, even when the market is screaming at you to do so.

And let’s be honest: most people who pick individual stocks have a certain amount of unwavering conviction in their picks. Whether you’re long or short, you probably believe that you’ve found something that everyone else has missed. You’re not easily swayed by volatility, because you’re certain that you’re right and the market is wrong. Unfortunately, this kind of thinking can lead to stubbornness, and stubbornness can lead to big losses.

The Allure of “Wonderful Companies at Fair Prices”

There’s a certain romance to the idea of finding “wonderful companies at fair prices” and holding them forever. This is the philosophy espoused by Warren Buffett and other value investors, and it has a certain appeal. After all, who wouldn’t want to own a piece of a company like Apple or Google and watch their investment grow over the years?

But here’s the thing: even Buffett has admitted that he’s made mistakes. And for every Apple or Google that you successfully pick, there are dozens of other companies that will disappoint you. The problem is that the world changes, industries evolve, and what seems like a wonderful company today might not look so wonderful in a few years.

Conclusion: The Case for Index Funds

So, if picking individual stocks is a fool’s game, what’s the alternative? The answer is simple: index funds. Rather than trying to beat the market, index funds allow you to be the market. By investing in a broad, diversified portfolio of stocks, you can capture the market’s overall returns without having to worry about picking winners and losers.

Yes, index funds are boring. They don’t offer the thrill of picking the next Tesla or Bitcoin. But they also don’t offer the heartbreak of losing your nest egg on a bad bet. And over the long term, they’ve consistently outperformed the vast majority of active investors.

So, the next time someone tells you about the hot stock they just bought, remember: the stock market is a giant casino, and in a casino, the house almost always wins in the end. Instead of trying to beat the odds, why not join the house?