Many retail investors are coming to the realization that stock picking is a losing game. The folks that lost all or most of their investments during the dot-com bubble of the 190s jumped back into the market thinking it was safe only to take a hit again by the great global financial crisis of 2008-09. At the lows of those dark days some investors sold out their holdings and decided to never again invest in equities. Who could blame them since their trust in the market was shattered not once but twice within a decade and they were shocked to see the bankers and others that created the crisis escaped scot-free. They were disgusted with the regulators such as the SEC who were supposed to monitor the workings of the market but slept at the wheel like a drunk driver and even when they took any action they were more of a slap in the wrist or even worse. Hence the idea that market is a rigged game where only the wealthy could play and multiply their wealth started to take hold.9

In general,  if retail investors wanted to invest in the stock market should they pick individual stocks or just go with passive funds?

The answer to the above question is it depends on the type of retail investor.For most retail investors individual stock selections will not work due to the time and effort involved in doing research, monitoring their positions, following up with all the earnings reports and so forth. For these people passive funds are the best option.

In  my opinion, people who are financially-literate and willing to do hard work and have time to follow the markets can go about building a portfolio made up of their own stock selections and other assets. Even for these folks winning in the equity markets is not a sure thing since any company can blow up regardless of how much time one spends reading all the publicly-available information. The collapse of bank stocks during the financial crisis is an example of this. However diversification is one strategy that can help to reduce volatility and survive a man-made disasters such as a dot-com or a credit crisis.

From a post titled “Keep Investing Simple” by Barry Ritholtz of chief executive of FusionIQ:

1 Go passive. Here is a dirty little secret: Stock-picking is wildly overrated. Sure, it makes for great cocktail party chatter, and what is more fun than delving into a company’s new products? But the truth is that individual stocks are riskier than broad indices. Managing those positions through the ups and downs is complicated and time-consuming, and most investors lack the skills and discipline to do it well.

Consider this: The world’s greatest stock-pickers got creamed in 2008. And the world’s worst stock-pickers made a killing in 2009.

Your solution is index ETFs, vastly preferable to picking individual stocks. Lower cost, reduced turnover, fewer taxes — and much less risk.

Here is  Roger Nusbaum, Portfolio Manager of  Your Source Financial on this topic from his recent article aptly titled Not All Stock Picking is Wildly Complex:

I wanted to continue on with a concept I brought up recently about stock picking despite the ruckus it raised. In trying to demystify stock picking a little I said that there are some stocks that can serve as reasonable proxies for decades. They may not “beat” the market but they can be great holds and don’t require a degree in forensic accounting to understand and follow.

While researching on the importance of diversification I came across a fascinating article published in 2009 by  William J. Bernstein in Money magazine. From Are stocks a loser’s bet?:

In fact, I wouldn’t be surprised if, after seeing the market go straight up for the better part of two decades, you’re now starting to wonder whether stocks are prone to lose money over time.

Well, guess what? Most stocks do lose money over time.

It’s a little-known and depressing fact, but the majority of individual securities tend to post negative returns over the long run.

In fact, researchers at the investment management firm Dimensional Fund Advisors found that from 1980 to 2008, the top-performing 25% of stocks were responsible for all the gains in the broad market, as represented by the University of Chicago’s CRSP total equity market database (see the chart at right).

As for the bottom 75% of stocks in the U.S. market, they collectively generated annual losses of around 2% over the past 29 years. (emphasis added)

Source:  Are stocks a loser’s bet?, CNN Money

Hence retail investors unable to spend the time and effort needed are better off owning diversified low-cost funds such as ETFs. For investors willing to devote time and continue to learn about equities through market ups and downs stock picking is the best option. Diversification and long-term holding of high quality dividend-paying companies for example can help them attain their goal.

Ten stocks to consider are listed below with their current dividend yields for investors looking to build a portfolio on their own:

1.Company: General Mills Inc (GIS)
Current Dividend Yield: 2.85%
Sector: Food Products

2.Company: The Coca-Cola Co (KO)
Current Dividend Yield: 2.88%
Sector: Beverages

3.Company: Union Pacific Corp (UNP)
Current Dividend Yield: 1.95%
Sector: Railroads

4.Company: Southern Co (SO)
Current Dividend Yield: 4.31%
Sector: Electric Utilities

5.Company: AT&T Inc (T)
Current Dividend Yield: 4.94%
Sector: Telecom

6.Company: Kimberly-Clark Corp (KMB)
Current Dividend Yield: 3.47%
Sector: Household Products

7.Company: Marathon Oil Corp (MRO)
Current Dividend Yield: 1.94%
Sector: Oil, Gas & Consumable Fuels

8.Company: T. Rowe Price Group Inc (TROW)
Current Dividend Yield: 2.01%
Sector: Investment Management

9.Company: Procter & Gamble Co (PG)
Current Dividend Yield: 2.94%
Sector: Household Products

10.Company: Caterpillar Inc (CAT)
Current Dividend Yield: 2.34%
Sector: Machinery

Note: Dividend yields noted are as of Mar 15, 2013

Related ETFs:

• SPDR S&P 500 ETF (SPY)
• Vanguard Dividend Appreciation ETF (VIG)
• SPDR S&P Dividend ETF (SDY)
• iShares Dow Jones U.S. Select Dividend ETF (DVY)
• PowerShares Dividend Achievers ETF (PFM)
• iShares Russell Midcap Index Fund (IWR)
• iShares S&P MidCap 400 Index Fund (IJH)
• iShares Russell Midcap Growth Index Fund (IWP)
• Powershares Dynamic Mid Cap Growth Portfolio Fund (PWJ)

Disclosure: Long GIS

Investors can the amplify returns of an investment in a stock by reinvesting dividends.This return known as the Total Return will be substantially higher than the Price Return  in the long-term  due to the effect of compounding. The difference in returns between the total return and price return will be especially significant for companies with above-average and growing dividend yields.

While this strategy works with stocks does it work with ETFs?

Since ETFs are similar to stocks in many aspects one can assume that this strategy will work with ETFs also. So in order to verify this assumption I did a quick check of returns using two of the largest ETFs for US stocks. The results show that total returns for ETFs is higher than price returns. Unlike stocks ETFs can have other distributions such as capital gains in addition to dividends. Hence the total return calculated for ETFs includes both dividends and distributions.

1)  Total Return vs. Price Return for SPDR S&P 500 ETF (SPY) from Jan 2,2008 to Mar 13, 2013:

Click to enlarge

As the chart above shows the gap between the two returns is indeed large. Reinvestment of dividends and distributions yielded 12.3% more than the return from price appreciation alone.

Currently the ETF has $125.0 billion in assets and a 2.04% distribution yield. The annual dividend yield is 1.99%.

2) Total Return vs. Price Return for SPDR Dow Jones Industrial Average ETF (DIA) from Jan 2,2008 to Mar 13, 2013:

Source: ETFreplay.com

The total return for this ETF is more than double that of the price return for the period shown.

Currently  the total assets of this fund is $10.0 billion and the distribution yield is 2.36%.The annual dividend yield is 2.29%.

Note: Distribution yields and asset sizes noted are as of Mar 13, 2013. Data is known to be accurate from sources used. Please do your own research before making any investment decisions.

Disclosure: No Positions

Diversification helps reduce risk and volatility of a portfolio. Some investors falsely assume that diversification eliminates risks altogether. This is not true. Diversification only helps to reduces risk but not eliminate it. For example, a well-diversified portfolio of stocks may fall 15% when the market falls 20% or 25%. In a major market crash such as the one we saw in 2008-09, diversification would have helped a portfolio from a complete wipe-out.

While one type of diversification can be achieved by building a portfolio of various asset classes, further diversification is important necessary the equity portfolio of the portfolio. Simply putting all the money  in one or two stocks or even five is a recipe for disaster. Depending on the size of a portfolio,one can diversify with 25-50 stocks. Since each stock behaves differently based the sector, earnings and so many other factors it is a wise idea to hold many stocks from a variety of sectors in order to  reduce the risk of loss.

The following table shows how not all stocks follow the market:

Click to enlarge

Note: 6. Source: Schwab Center for Financial Research with data from Standard and Poor’s. Total return includes reinvestment of dividends.

Source:  The Portfolio Pyramid: How to Diversify Your Stock Investments, Charles Schwab

In 2002, the S&P 500 index fell about 22.0% but 131 of the index components were up that year. Similarly in 2012, the S&P 500 had a total return of 16.0%. However not all the companies in the index was in the positive territory for the year. In fact, 107 of the index components had negative performance.  Even during the major market meltdown in 2008 when the S&P 500 fell 37.0%, there were 25 stocks that went up.  Since it is impossible to predict the future performance of stocks precisely, diversification is one way to play it safe.

The Journal had an interesting story about a barber and former investor Mr.William Flynn. Mr.Flynn lost  most of his fortune during the bubble days of dot-com mania by putting his money in just one company – EMC Corp. (EMC). Later in 2007, he got wiped out again when he invested all his money in only one company for the second time. This time it was Eastman Kodak Co. that later filed for bankruptcy. This unique case is a reminder of how investors can easily lose their hard-earned money if they fail to diversify. The benefits of diversification cannot be underestimated. Diversification matters whether an investor has only $28.0K to invest or has $2.80 million to invest.

From the article:

Mr. Flynn claimed to have put 100 friends into EMC stock in 2000, including Mr. Capobianco. After Mr. Flynn’s appearance in the Journal in March 2000, EMC invited the barber to a shareholder’s meeting to meet company executives. Mr. Flynn later wore a jacket emblazoned with the EMC logo around town.

The barber held EMC stock to a peak of about $130 a share, only to ride it back down to less than $4. His fortune began with $150,000, swelled to $834,000 in September 2000, and then shrank back to about where it started.

Mr. Flynn said his wife, Jean, panicked. She had always worried about her husband’s big stock market bets. Mr. Flynn, meantime, said he grew forlorn.

“My wife and I were really shook up by it,” he said. “I was so despondent over it, I just let it go. I thought to myself, ‘If it comes back, it does. If it doesn’t, then, well….'”

EMC closed Friday at $24.30.

Mr. Flynn took a breather from trading before getting back into the market in 2007. He put some money in Eastman Kodak Co., EKDKQ +3.47% at the urging of a stock broker. The camera-maker filed for bankruptcy last year, wiping out the barber’s $28,000 investment.

A few weeks ago, Mr. Flynn made a decision to sell what was left in his portfolio. “I’ve been thinking about it a long time, and my wife and I talked about it,” Mr. Flynn said. “We came to the conclusion that the stock market is just not for us.”

Related ETFs:

SPDR S&P 500 ETF (SPY)

Disclosure: No Positions