Should You Pick Stocks?

Over the past few weeks, productivity across America has dropped, and men are replacing women as the object of fantasies. It must be football season.

It's a hot topic here at Fool HQ as well, with fantasy leagues and pools and the hurling of dead pigs consuming company time. Which is not surprising, since stocks and sports often attract the same people. In fact, I have a theory that stock-picking replaces sports-playing as we age and find it too hard (and humbling) to get eight friends together to play football in the backyard.

But investing shouldn't be a game. Your lifestyle, your kids' educations, your family's security, and your retirement are all at stake. So should you be spending your time picking individual stocks, or should you have a well-diversified portfolio made up of low-cost funds?

That depends on your rating.

MVP or wannabe?
If investing were a football game, would you be Peyton Manning or Rex Grossman?

Last season, Manning had the highest quarterback rating in the league. He also led his the Indianapolis Colts to victory in the Super Bowl and was named the game's Most Valuable Player.

That victory came over the Chicago Bears, quarterbacked by Rex Grossman. Like Manning, he led his team to the Super Bowl. Also like Manning, his quarterback rating was above 100 in seven games; only one other quarterback (Marc Bulger of St. Louis) had more 100-plus games. In the second game of the season, Grossman earned a rating of 148, several points higher than Manning's (or Bulger's) season best.

However, as any Chicago native (including me) will tell you, Rex Grossman is no Peyton Manning -- at least not yet. While Manning only earned one QB rating below 60 last year (and that was against the Ravens vaunted defense in the playoffs), Grossman had five games where his rating was below 37. That's abysmal. In the final game of the season, his rating was a big, fat zero after throwing three interceptions and getting benched.

Dink and dunk or go deep?
What do these two quarterbacks have to do with your portfolio? There are two sides to every investment: how much might it make, and how much might it lose. Most investors, Fools included, love to talk about the good stuff -- the gains. Yet investing is just as much about controlling risk and uncertainty. After all, if you knew which investment would be the best performer over the next year, you'd be a fool to diversify; you'd just load up on next year's winner. But in the absence of such foresight, you should spread your money around.

Yet some intelligent, experienced investors -- the Peyton Mannings of investing -- have demonstrated a skill to be more right than wrong when it comes to picking the winners of tomorrow. For these folks, diversification can be a detriment. During the 2005 Berkshire Hathaway annual meeting, Vice Chairman Charlie Munger turned to Chairman Warren Buffett and asked, "When was the last time you sat down and wrote out an asset-allocation plan?" Buffett replied, "Never." When you have Buffett's record, you don't need traditional asset allocation.

Similarly, if Peyton Manning has Joseph Addai open in the flat but Marvin Harrison is also streaking down the sideline, he can take the long shot with confidence. However, Grossman, when given the option of a short toss to Cedric Benson or a heave to Muhsin Muhammad, should go for the surer thing. He'll increase his chances for a gain and decrease his chances of an incompletion or an interception. In other words: some return, less risk.

Managing your terminal wealth
Why should you care about risk? It depends on how you define the word. If it's just day-to-day volatility, then it can be ignored. However, if it's the likelihood that you'll have the money you need, when you need it -- the best definition of investment risk -- then you need to pay attention.

The academics call it a "dispersion of terminal wealth," which means that the dollar amount an investor actually will have is unknown. In fact, it will likely fall into a range of values. If you invest only in cash, that range is very small. If you invest in stocks, that range is very large. We've all heard that stocks return an average of around 10% a year. However, according to Ibbotson Associates, the range of annualized returns over 10-year periods since 1926 was -0.9% to 20.1%. Assuming a $10,000 initial investment, those two 10-year periods would have left investors with either $9,136 or $62,435. That's a big difference in "terminal wealth" and, more important, will likely determine some aspect of the investor's life, whether it's a retirement date or the features on a new car. 

Those ranges in terminal wealth get even more striking with individual stocks. Check out the wealth-creating or -destroying histories of this sample of stocks:

So when it comes to determining your asset allocation, start by looking at your "investor rating," which is your long-term performance. Have you proven over a period of several years (at least 10) that your investments turn out to be the wheat rather than the chaff? Has your portfolio's performance beaten a relevant index over that period? If you have hard, statistical evidence that you've got what it takes to be a superior investor, you can concentrate your portfolio with confidence.

Until you have those skills, however, broad diversification is the way to keep moving down the field without losing the investment game. In my Rule Your Retirement service, I regularly discuss the art of asset allocation, and provide model portfolios to get you started. They should form the foundation of your portfolio, at least until you've honed your skills. Just as it may be only a matter of time until Rex Grossman is the next Peyton Manning (check out Grossman's collegiate stats), you might have a little Warren Buffett in you after all.  

Robert Brokamp is the advisor of Motley Fool Rule Your Retirement, which you can try free for 30 days. He fully recognizes that he has never been the quarterback of a Super Bowl team and that Rex Grossman could kick his butt, so you Bears fans can keep your all-capped emails to yourselves. Berkshire Hathaway is a Motley Fool Inside Value and Motley Fool Stock Advisor recommendation. The Fool has a disclosure policy.