Two methods of investing in stocks make equally good sense to me. The first is to choose a broadly diversified basket of stocks. This is usually accomplished by purchasing shares in an index mutual fund or ETF, such as one that tracks the S&P 500. Investing in this manner will result in wide diversification and average returns. Average returns might sound second rate, but they are nothing to be ashamed of. Assuming prices are reasonable when you buy and sell, average performance can be quite satisfactory. Plus, this method saves time. And for the industrious, time is money.
A second method that deserves attention requires a good deal more effort and skill. This method, I will call it “value-based active portfolio management”, involves picking a group of individual stocks that are believed to be selling at attractive prices relative to their valuations.
In order to succeed in applying this method, one must have a good understanding of business value. The investor must exercise great caution since bargains are often just mirages. If a stock looks cheap, you’ll usually get what you pay for. Great patience and persistence is also required. Analyze a hundred different stocks, and you might find one worth your while. The investor must also be independent-minded. Otherwise, how can he or she expect to perform any differently from the average? Rather than “ride the tides,” value-based active portfolio managers rely on their individual abilities and efforts to drive portfolio growth. The more abilities and effort, the better the performance.
Both ways of investing in stocks can be perfectly sensible depending on who the investor is and how much effort and time he or she wants to put forth. I have chosen the second method because I think I can do well and because I am willing to put in the hard work. If someday I find myself at a point where I am no longer able to put in the time and effort, or if I no longer believe I have what it takes to succeed, I expect I would seriously consider switching to an index approach.