By Michael J. Wiener
Special to the Financial Independence Hub
Many people advocate having a portfolio made up of mostly a core of low cost index funds along with a small “explore” part for taking concentrated risks on favourite investments. This can work well enough if you’re realistic about it, but most investors cross the line to self-delusion.
Ben Carlson does a good job justifying the existence of explore-type investments in his article The Case for Having a Fun Portfolio. After all, people are entitled to spend their money however they want. Not every expenditure has to be part of a logical long-term plan. We can buy a beer, or a motorcycle, or some favourite stock if we want. So what if the long-term expectation is that the explore part of people’s portfolios will underperform indexes.
All the logic makes sense up to this point. But just about every stock-picker I know can’t resist taking this a step further. “Besides, the stock I picked is going to do great.” In their hearts, they know their stock picks are going to outperform. Past results don’t seem to deter them. They wouldn’t bother with the explore part of their portfolios if they truly believed they would lose money over a lifetime of picking stocks.
All the evidence says that professional investors today set good relative prices so that individual investors who choose their own stocks are essentially making random picks. The odds are against the small guy, but hope springs eternal. I prefer to find hope in other pursuits.
Michael J. Wiener runs the web site Michael James on Money, where he looks for the right answers to personal finance and investing questions. He’s retired from work as a “math guy in high tech” and has been running his website since 2007. He’s a former mutual fund investor, former stock picker, now index investor. This blog originally appeared on his site on April 26, 2021 and is republished on the Hub with his permission.
A sampling of comments from the original post:
Reader Comment: For me, having a tiny portion of my portfolio reserved for “exploring” ends up acting as a confirmation bias. I have had a few great winners but mostly moderate losers in the explore portfolio. To me this confirms that I cannot beat the market consistently. Suffering slightly below market returns on the explore portion helps stay focused on the long term strategy of low-cost, globally-diversified index funds.
Michael: If that works for you then great. You’re definitely in the minority.
Robb Engen: This is one instance where mental accounting has served me well (I think). I’ve wasted all kinds of money throughout my life, no doubt. But if I’ve gone to the trouble of contributing money to an investment portfolio, I want all of that money put to work in a low cost, globally diversified, and risk appropriate portfolio. That leaves no room for speculation. I could not fathom allocating 5% or 10% of my portfolio to speculative bets just to scratch an itch (especially in my RRSP or TFSA where I’d lose that contribution room if my picks lose money).
Michael: Hi Robb,
All human biases I’m aware of that get pointed out by behavioural economists serve us well in some contexts.
I find it interesting that someone who would never risk $100 on a hand at a blackjack table has no problem risking $10,000 on some stock. Not that I recommend playing Blackjack, but the risk of loss is much greater on the 100x “investment” in the stock.
Reader Marteau: I use my TFSA for the fun/speculative/stock picking portion of my retirement plan. I mostly have dividend stocks in there. Taking into account that I’ve contributed the max up to now ($75,500) and that my TFSA is worth $126.5K (~70% gain), I’m happy with selections. I’ve been lucky/fortunate with my picks. I’ve got 13 individual stocks: ENB and GCL are my only “losers”. BLX and CP are my biggest winners.
Michael: Depending on when you made the contributions, your result may be better or worse than an index. You’d have to go back and simulate equal investments in an appropriate index at the same times to be able to tell. Another thing to consider is that everyone feels like a genius in a bull market. I remember this well in the run up to the year 2000. The next substantial and long-lasting stock crash will bring more realism.
Marteau: Agree with what you write. With yearly contributions, would be difficult to figure out. I’ve also not kept track of what was bought when. And sometimes I was reinvesting dividends and sometimes I wasn’t. And yes, of course I’m a genius. ;-) My RSP portion, which contains more than 75% of my retirement funds is in index funds