Your broker calls.  He repeats a familiar refrain: Our analysts have adjusted their target price on X stock to Y dollars a share.  We think you should add this stock to your portfolio.

Surely, the “analysts” at top firms know more than you.  Their entire job is focused on studying a limited number of stocks and uncovering mispricing that can benefit you, right?

Few investors understand everything about this scenario is fundamentally flawed, and designed to transfer your wealth to your broker and his (or her) firm.  Here’s why:

Don’t buy individual stocks 

For most investors, it makes no sense to own individual stocks.  The expected return of a stock is the same as the index to which it belongs, but the risk is significantly higher because of what’s known as idiosyncratic risk – the risk unique to that company.  You can easily diversify away this risk, without sacrificing your expected return, by owning an index fund.

Yet, the lure of picking the next big “winner" causes many investors to be easily seduced by the call from their broker.

If you are interested in more data that should persuade you not to own individual stocks, it’s summarized in this excellent blog post.

The analyst scam

Here’s information your broker really doesn’t want you to know.

The track record of analysts is terrible.  Rather than relying on them, you might do better tossing a dart at a listing of stocks on the major exchanges.

One study (discussed here), looked at the recommendations of more than 11,000 analysts from 41 countries.  The overall accuracy of their “target prices” was a puny 18% for a 3-month period and 30% for a one-year time frame.

The combination of the risk of individual stock ownership and unjustified reliance on the purported expertise of analysts makes the answer to my hypothetical call from your broker a no-brainer.

Thanks.  I’ll pass.

Resource of the Week

This blog post discusses the study that found analysts’ target prices are “rarely accurate.”

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