I wish fewer people would talk about investing. Fewer “personal finance” bloggers, fewer pundits on TV, and fewer lay people over lunch breaks. If someone isn’t flat-out telling you to buy Google and sell Microsoft, they are busy bragging about their most recent home-run investment that returned 100% in just 3 months. Or they’re talking about “dividend growth investing” which is nothing more or less than stock picking.
Of course, these media sources forget to disclose the track record of the so called “guru” who is making recommendations and predictions and everything between. If that information was brought to your attention, you’d immediately ignore everything being said.
Why Stock Picking Fails
Three words: Relative Market Efficiency
Stock prices are constantly adjusting to the news that is available to all market participants. Without insider information, it’s impossible to predict future news. Can you tell if Apple will fall above or below their next earnings forecast? I don’t think so. If you had that magical ability, you’d be wealthy beyond imagine.
Stock pickers wrongly presume two things:
- There are mispriced securities that can be identified in advance
- These securities can be readily exploited for profit.
They don’t realize that virtually all of the information about a stock, a sector, or an economy is very quickly digested by the entirety of market participants and swiftly embedded into the price of that security. Stocks are always “priced fairly” given the current information that is publicly available. This dynamic ensures that current market prices are the best estimate of fair market value, as agreed upon between willing buyers and willing sellers. Even if a security is priced in a way that is not supported by the underlying fundamentals, that “mispricing” can continue for many months or even years.
In other words, when you try to buy underpriced “winners” or sell overpriced “losers,” you have to think the person on the other side of the trade is misinformed or stupid. Why else would they be taking the opposite position?
Millions of investors, and an army of brokers, believe their own personal version of this fairy tale.
Consider an online newsletter that shares “insider secrets” and recommends certain stocks. What are they basing these recommendations on? The only information they have is widely available to the public, for free.
If the newsletter worked, why would the author be sharing that information? Why not just keep the secret and make a fortune picking stocks? Furthermore, if the recommendations were sound, who on this planet would be willing to part with a stock rated “buy” and sell it to you? And what kind of dimwit would later buy when the recommendation was sell?
The reasons that newsletters underperform the market is the same reason that individual investors underperform the market when trying to pick winning stocks. They overestimate their knowledge and ability to predict the future.
Remember, when you decide to trade individual stocks, you’re competing against Warren Buffett, the giant Yale endowment fund, corporate insiders, and an army of Ph.D. quants who stare at numbers for 14 hours each day. Why do you think you have more information than the professionals on the other side of the trade?
And even if you somehow did know more than those people, what makes you think that anyone can predict the future movement of a security? You can’t! And neither can most professionally managed mutual funds and hedge funds.
Research on the Failures of Stock Picking
My argument is further strengthened by the growing body of empirical research that is now available on this topic. Let’s take a look at a few examples where neither mutual fund managers, nor individual investors could select winning stocks.
Professionals Can’t Pick Winners
The New York Times article, “The Prescient are Few” (1) offers a great look at the study (2) by Professors Laurent Barras, Olivier Scaillet and Russell Wermers about the performance of 2,076 professional mutual fund managers over a 32-year time period.
The result are what I’d expect. They found that from 1975 to 2006, 99.4% of these managers displayed no evidence of genuine stock picking skill, and the 0.6% of managers who did outperform the index were “statistically indistinguishable from zero.”
Professor Wermers goes on, “This doesn’t mean that no mutual funds have beaten the market in recent years. Some have done so repeatedly over periods as short as a year or two. But the number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives”
In other words, they got lucky.
And he finishes with some sage advice:
“Until now, I wouldn’t have tried to discourage a sophisticated investor from trying to pick a mutual fund that would outperform the market. Now, it seems almost hopeless.”
Individuals Are Even Worse
Professors Brad Barber and Terrance Odean have done excellent work on this topic. In their paper, “The Behavior of Individual Investors” (3), they review and summarize the vast amount of research on the stock trading behavior of individual investors. Their findings are remarkable:
- Underperform standard benchmarks (e.g., a low cost index fund)
- Sell winning investments while holding losing investments (the “disposition effect”)
- Are heavily influenced by limited attention and past return performance in their purchase decisions
- Engage in naïve reinforcement learning by repeating past behaviors that coincided with pleasure while avoiding past behaviors that generated pain
- Tend to hold undiversified stock portfolios
They took another stab at it with excellent research paper titled “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors.” (4)
Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that traded most earned an annual return of 11.4 percent, while the market returned 17.9 percent. Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.
What about investing in reputable companies?
We can go further still and show that most investors also underperform the market by choosing to invest in featured companies that are famous, well received, or well publicized.
In their book, Creative Destruction (5), Richard Foster and Sarah Kaplan analyzed the companies of the original S&P 500 Index created in 1957. Quite shockingly, only 74 of the original companies remained on the list in 1997, and just 12 of them ended up with returns that outperformed the index for the 41-year period through 1998. 12 out of 500!
Keep in mind that these 500 companies are some the biggest and most influential in the world. They are not small, distressed firms that you’ve never heard of. They are giants that people love to talk about. Just think about how many people bought the stock of these “safe investments” while trying to outperform the index.
And the authors sum up the problem with stock picking quite well:
“As the ’80s passed and we made our way through the ‘90s, both of us observed that almost as soon as any company had been praised in the popular management literature as excellent or somehow super durable, it began to deteriorate.”
If you still aren’t convinced, have a look at the 2010 study “Stocks of Admired Companies and Spurned Ones” (6) by Meir Statman and Deniz Anginer.
The study was based on Fortune Magazine’s annual list of “America’s Most Admired Companies” from 1983 to 2007. The authors created two portfolios from the data, with one representing the most admired companies and the other representing the “spurned” or least admired companies. The “admired” portfolio contained the stocks with the highest Fortune ratings (which were popular companies like Disney and Google), and the “spurned” portfolio contained the stocks with the lowest Fortune ratings (which were no name companies like Jet Blue and Bridgestone).
Can you guess the outcome?
“Stocks of admired companies had lower returns, on average, than stocks of spurned companies. 16.12% annualized return of the spurned portfolio versus the 13.81% annualized return of the admired portfolio over the nearly 25 year span.”
Not only that, but they found exactly the same results as the authors above.
“We find that increases in admiration were followed, on average, by lower returns.”
More media coverage and hype results in more popularity, which causes more people to buy the stock. This results in higher stock prices and ultimately, lower future returns.
The research is clear. Investors lose when they trade frequently and attempt to pick winning stocks.
On average, individual investors and actively managed mutual funds will underperform an appropriate benchmark on a risk-adjusted, after-tax basis. This has been shown time and time again.
Of course there will always be anomalies, but who cares? By definition, you’re probably in the overwhelming statistical majority who is wasting time, effort, and money chasing returns that will never be found.
If you want to “outperform” the market, follow the research. Invest in index ETFs that track small companies and those that are not publicized (value and/or low-beta companies). In doing so, you can take advantage of low fees and diversification benefits, while avoiding the stock picking trap. If past returns persist, you’ll manage to outperform the broad market by a few basis points each year without trying to play this ridiculously stacked game.
And how about the million dollar question: If stock picking is so hopelessly futile, why does the media continue talking about it? Why do brokers continue selling it? Why do individual investors keep chasing it?
A couple of reasons actually.
- People are suckers who love a good story. Research and reason don’t sell magazines. No big brokerage firm is going to place a full-page ad that says, “Trading your portfolio with us will cost you a fortune over time in fees and expenses, therefore you’re almost guaranteed to underperform an appropriate index ETF.” No, they keep hawking the latest high tech mutual fund, selling the dream while collecting those fees.
- But even more likely: People desperately want to be better than the average, and smarter than the next investor, even though they probably aren’t either. We’re all sharing the same information, and this isn’t Lake Wobegon.
The best way to win this game is by refusing to play it. Invest in a global mix of low-expense, index ETFs, or find a low cost solution like Betterment to invest in those same funds for you.