DIY stock picking
I've earned about 35% on my stock picks over the past 14 months and plan to invest about $5,000 a year this way. Should I continue picking stocks on my own?
By Walter Updegrave, MONEY Magazine senior editor

NEW YORK (CNNMoney.com) - My wife and I are 32 years old and contribute 15 percent of our combined income to our retirement savings plans at work. We have about $150,000 in those plans. I've also invested about $7,500 in stocks through an online broker and have earned about 35 percent on my picks over the past 14 months. I feel comfortable with what I am doing in the stock market and plan to invest about $5,000 a year this way. Do you think I should continue picking stocks on my own?

- Bobby Hart, Central Square, New York

At first glance, you appear to be doing a pretty good job as a stock picker. Your 35 percent return over the last 14 months handily outdistances the broad stock market as measured by the Standard & Poor's 500 index, which was up about 9 percent. And your return also easily beats that of the small-stock Russell 2000 index, which was up about 22 percent over that period.

In reality, though, it's difficult to tell based on what you've told me whether your return reflects true expertise as a stock picker.

Could it be luck?

Why? Well, for one thing, you may be investing in stocks that are much more volatile than the shares in the two benchmarks I mentioned above. In that case, your higher gains may simply reflect the fact that you're willing to take a lot of risk to get higher returns, not that you possess genius stock-picking skills. A better gauge of whether you're a terrific stock picker is whether your returns are still higher than those of an appropriate benchmark after adjusting your returns for risk.

Let's also keep in mind that we're dealing with a very short period here, a mere blip in time. It's not unusual for someone with little expertise to rack up outstanding gains over a short period of time. Just take a look at major league baseball standings early in the season. You'll often find teams with marginal talent that get off to a great start only to find themselves gradually descending into the cellar later in the season.

Which is another way of saying that your outsize gains may be due simply to luck. In fact, it's difficult to tell even with highly successful professional money mangers whether their performance is really due to skill rather than luck. When you have millions of people investing, there are always going to be some with outstanding results. The acid test of whether those results stem from skill is whether the manager can re-produce those results over long stretches, like 10 or more years.

Check your gut for risk tolerance

As to whether you should continue with your plan to invest five grand or so in stocks each year, ultimately that's a personal decision. I'm not a big fan of buying individual stocks because I feel the chances that an individual will outperform a broad benchmark after adjusting for risk, transaction costs and the time and effort involved are slim at best.

But if you're going to go about this systematically, doing actual research, carefully monitoring your holdings and not letting your success get in the way of disciplined stock picking (like so many bull market geniuses during the dot-com craze did), then my feeling is give it your best shot.

If you do decide to go ahead with your plan, I have a few recommendations.

First, just to see what sort of risks you are taking, go to theRiskGrades site and plug in all your individual stock holdings. You'll immediately be able to see not only the risk level of each individual stock, but the risk level of all your stocks as a group after accounting for the way they zig and zag in relation to one another.

While you're there, you might as well also create a portfolio that includes your retirement savings and your individual stocks. This way, you'll see what sort of risk you're taking with all of your retirement investments overall. After doing this, you should have a better sense of whether your success is being driven more by the volatility of your picks as opposed to your investing acumen.

Don't day-trade

Second, I'd resist the urge to do rapid-fire trading. Many investors who are just getting into stocks mistakenly believe that the best way to boost their profits is by frequent trading. And, on the surface, that logic seems to make sense. If you have an eye for identifying stocks that will go up in value, won't you make more money the more stocks you pick?

Fact is, though, that chronic trading often leads to subpar performance, both because investors often end up dumping stocks that do better than the stocks they replace them with and also because transaction costs act as a drag on returns. University of California finance professor Terrance Odean has written extensively on how frequent trading affects returns, and you can read what he has to say on this subject by clicking here.

Third, rather than view your stock picking as its own little enterprise, try to integrate it into your retirement investing plan. If your retirement plans have plenty of good large-cap stock funds but don't offer many mid- or small-cap choices, you might focus your stock picking in the small-cap arena. For more on the rationale behind this holistic strategy, or what I like call the "whole enchilada" approach, click here.

Finally, keep careful tabs on your results. If you find that in the future you have more and more trouble replicating your stellar results of the last 14 months, you can always switch to mutual funds.

_________________________

More recent Ask the Expert columns:

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.