Stock Picking Is for Fools (and You’re the Punchline)

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One of the most annoying observations I get about my “Smartest” series of books is that they are fine for “beginners,” but not sophisticated enough for “seasoned investors.” The thrust of these comments is that “seasoned investors” have both the time and expertise to pick stocks that will “beat the market,” so they should not settle for the “average returns” of index funds.

There’s so much wrong with these sorts of comments it’s hard to know where to begin. While they are often made with overbearing smugness, they are never accompanied with hard data, which is not surprising. Here’s a small sample of the data supporting my premise that stock picking is for fools.

Mutual Fund Managers Don’t Have Stock Picking Skill

Most individual investors who claim to have stock picking skill are employed in jobs unrelated to the securities industry. They work at picking stocks in their free time, by doing “research” or following recommendations in the financial media.

Mutual fund managers devote themselves full time to trying to identify and exploit mispriced equities for inclusion in their portfolios. They have vast resources at their disposal. They are highly incentivized. Their compensation -– and often their continued employment -– depends on their ability to beat a risk-adjusted benchmark.

What’s their track record? One study looked at the performance of 2,076 mutual fund managers from 1975 to 2006. It found that 99.4 percent of the fund managers studied displayed no evidence of genuine stock picking skill. The balance of 0.6 percent who outperformed their benchmarks were “just lucky.”

For you to believe stock picking is a good option, you’d have to conclude that you possess a skill which has eluded the best, brightest and most highly compensated professional mutual fund managers in the market. Really?

Hedge Fund Managers Don’t Have Stock Picking Skill

But what about hedge fund managers, those “masters of the universe,” some of whom make billions of dollars managing other people’s money?

All you need to know about the myth that hedge fund managers have stock picking skill is set forth in a Bloomberg article headlined “Hedge Funds Are for Suckers.

The article notes the “reversal of fortunes” of many hedge fund managers. It found that in eight of the 10 years prior to 2013, simple market-based index funds posted superior returns “although most fund managers still charged enormous fees in exchange for access to their brilliance.”

The premise that the most “brilliant” fund manager, armed with the fastest computers, can “make miracles” by uncovering inefficiencies in the market or predicting the future has not been borne out by the reality of hedge fund underperformance.

As an amateur investor, regardless of your time and expertise, do you think you have better stock picking skills (and greater resources) than hedge fund managers?

Do You Know the Odds?

Presumably, the reason you engage in stock picking is to enhance the returns of your portfolio. To accomplish this goal, you basically have three choices.

  1. You can purchase a globally diversified portfolio of low management fee index funds, passively managed funds or exchange-traded funds in a suitable asset allocation.
  2. You can purchase a globally diversified portfolio of more expensive actively managed funds, in a suitable asset allocation.
  3. You can engage in stock picking, where you put together your own globally diversified portfolio of stocks and bonds in a suitable asset allocation.

In my books, I advocate for option No. 1.

Clearly, option No. 2 makes no sense given the lack of evidence for the existence of genuine stock picking skill on the part of active mutual fund managers.

In order to assess option No. 3, you need to understand the odds of a portfolio of 10 equally weighted actively managed funds, rebalanced annually, beating the performance of a comparable portfolio of index funds. Over a 10-year period, the probability of market-beating returns is a puny 0.055 percent. You can find details underlying this calculation here.

No rational person, objectively viewing this data, would take those odds.

Index funds don’t give you just average returns

Over periods of 10 and 15 years, index funds managed by two leading fund families, Vanguard and Dimensional Fund Advisors, outperformed the majority of comparable actively managed funds. When survivorship bias and taxes are considered, the performance of these funds would have been even higher.

Contrary to the often repeated mantra that “index funds give you average returns,” the irrefutable fact is that index funds can give you above-average returns.

The next time someone tells you not to settle for “average returns” by buying index funds, show them this data and ask them to show you theirs.

The Takeaway

Stock picking is a cruel joke perpetuated by the securities industry and much of the financial media. It is a pretense used to transfer money from your pocket to those who “manage” it.

Don’t be fooled by the hype. It’s time to stop being a victim and change the way you invest.

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