Earlier this week, I had lunch with Rob Arnott, the founder of Research Affiliates and the sort of godfather of alternative stock-market indexing.
I was telling him about a recent story I wrote for younger investors about how much of their portfolio they should have in ETFs versus individual stocks.
The takeaway from the story, based on chats with four financial professionals, was that retail investors should simply stay away from the idea of stock picking altogether and have virtually all of their equity holdings in index funds.
The competition, they said, is too steep, and the necessary research takes too much time. Plus, even the pros have a hard time beating the market; just 15% of funds beat the S&P 500 over the last 15 years, according to SPIVA data.
Arnott said it wasn’t bad advice. But never one to go completely with the consensus, he also pushed back and made the case for why young investors should actually have a go at stock selection with part of their portfolio if they want to — not for the potential returns but for the learning experience.
“They should dabble a little bit,” Arnott said. “Enter into it expecting to do worse than your ETFs. View it as tuition.”
Investors can learn a few lessons in humility from taking a few swings in the market, Arnott said. Sure, humility is a great quality for navigating life in general, but Arnott said it can be particularly helpful in investing when it’s learned early.
For instance, it will expose blind spots in what you know about a stock and markets. It will also reduce the tendency to chase recent outperformance, and teach you to challenge prevailing narratives.
“They’re more likely to develop a respect for patience,” he said. “They’re more likely to develop a disdain for relying on recent performance to make your decisions. What’s done best in the last three years often is among the worst in the next three years.”
The financial experts I interviewed for the aforementioned recent story said that if an investor really wants to pick individual stocks, they should only designate around 5% or less of their portfolio to doing so.
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But Arnott said it’s fine if you want to go bigger.
“I think the 5% threshold for most young investors is going to be too small to even bother,” he said. “I mean, a newbie with $10,000 — what are you going to do with $500?”
Still, there are fractional shares these days, and investors can keep their bets — or their tuition, as Arnott puts it — as small as they want. Once an investor builds up $40,000-$50,000, capping their individual bets at something like $10,000 and having the rest in ETFs isn’t a bad approach, Arnott said.
While his advice on stock picking isn’t as conservative as what you’ll hear from a financial advisor, Arnott doesn’t support a risk-on approach in every sense. In fact, at the moment, he said it’s probably smart to have a higher-than-normal allocation to bonds given how elevated broad stock-market valuations are. The S&P 500, for example, should deliver lower than 1.5% average annual returns in the next decade, he said, based on the historical relationship between starting valuations and subsequent returns.
Within stocks, some cheap areas of the market include international and emerging markets value and small-cap value, he said.
For those who plan to buy-and-hold for multiple decades, however, index funds are probably still the best approach. If you want to have more of an active hand in your portfolio and rebalance from time to time, placing more niche bets may also prove advantageous.
Yes, even if that means taking on the high level of risk that comes with buying individual stocks, which financial advisors so often warn against.
As Arnott sees it, some good will come of it either way. So go ahead and swing away.
