Beware the Misleading Stock Picking Stories

6 June 2017  |  Adam French
Beware the Misleading Stock Picking Stories
I was frustrated to open the papers and see yet another active manager endorse the success of their strategy by using just one example.
I want to debunk this nonsense and discourage such irresponsible investment management.

Time and time again I open the newspaper to see yet another active manager endorsing their own investment style. The arguments used are invariably based on the success of one stock they happened to have got lucky with, forgetting to mention their less fruitful investment decisions. They use this one stock as evidence that active management works better than any other investment strategy.

I think that this argument is highly irresponsible. Use of one turbulent stock to define the success of active management? I most recently saw Amazon used as an example – the article explained that had savers invested in Amazon at inception and stayed invested until today, that investor would have generated returns 210 times greater than those from the S&P 500 over the same period.

Investors reading about Amazon may then be encouraged to try to work out which startup would be most suitable for their lifetime savings. The article neglects to mention the emotional turbulence that an Amazon investor would have suffered and interestingly, the word ‘risk’ is not mentioned once throughout the whole article.

I want to debunk this nonsense and discourage such irresponsible investment management. One success story does not prove that an investment strategy works. Furthermore, it definitely doesn’t provide evidence that active management (stock-picking) works – rather the opposite.

Success Not Guaranteed

An investor that bought into Amazon in the early days will have suffered daily declines of 6 percent over 200 times and losses of 15 percent over 3 days more than 100 times. They will not have slept well through the dotcom crisis when Amazon lost 95 percent of its value. If choosing the right stock in the first place isn’t hard enough, keeping faith in it is even harder. How many of the original investors are still invested in Amazon today? Not many I suspect. Risk has been unpredictable and deeply volatile; those are not the sort of words that you want your life savings exposed to.

At least Amazon is still going – those savers of the late 1990s could easily have chosen online auctioneer Onsale for their savings, or online music retailer CDNow. Both companies went public at around the same time as Amazon and both went bankrupt shortly after. Pinning your financial future to one stock is a seriously risky business.

Those investors who choose stocks for a living don’t seem to get it right very often either. As at 31 Dec 2016, 88.3 percent of large-cap funds in the US had underperformed the S&P 500 over 5 years. Europe didn’t fare much better with 74.2 percent of funds underperforming the S&P Europe 350 over 5 years.

The Vast Majority of Active Funds Underperform Their Benchmark

Percentage of European equity funds that underperformed their benchmarks, as at 31st Dec 2016

Percentage of European equity funds that underperformed their benchmarks, as at 31st Dec 2016

Past performance or future projections are not indicative of future performance.
Source: Spiva Statistics and Reports

These examples illustrate the importance of controlling risk. Any investors trying to find ‘the next Amazon’ would be better off finding a new investment strategy. To generate decent long-term returns, risk should stay under control.

Another Way

When it comes to investing, risk and reward are closely related – more risk tends to be rewarded. At least in the long term. However, the risk we associate with a certain type of investment – such as the FTSE – can markedly increase over a few weeks, or even months every year. These periods of excess risk are slightly different. These are often driven by short-term uncertainty and typically go hand in hand with lower, sometimes negative returns, punishing investors instead of rewarding them. By making adjustments based on volatility and keeping risk carefully controlled, risk-adjusted returns will be smoother and better. An investor is much less likely to be exposed to and punished for taking excess risk.

By reducing exposure to an asset class when it’s going through a period of unusually high volatility, investors can generate a better performance than the active stock-picking approach discussed above. This is possible because during periods of low volatility, the saver will still be invested in typically higher-risk assets, such as equities. Crucially though, they avoid those periods of negative performance that tend to come just before the periods of increased volatility.

Successful risk management, therefore, creates portfolios that work in all market environments.

Our Dynamic Risk Management

It’s this style of investment management that we employ. We pick up tremors of volatility in the markets and then adjust our portfolios according to our clients’ individual risk tolerance. This ensures that our clients never exceed the level of risk that they are comfortable with in the long term, or that they end up in a portfolio that is too conservative and misses out on performance potential. We avoid that potentially punishing exposure to excess risk and therefore generate a better return for every unit of risk an investor is exposed to.

We regularly adjust asset class weightings according to the defined risk category for each portfolio. We call this dynamic risk management and believe that this style of investing drives better risk-adjusted returns over the long term.

In Conclusion

A one-off example of success proves nothing. I sincerely hope that anyone reading articles that use one stock to endorse active management pause for thought before making any investment decisions.

By not allowing risk to jump around, investors will avoid the emotional turmoil associated with active management and their long-term returns will see the benefit. Dynamic risk management works for everyone in all market conditions. I think that is a more responsible solution to describe to savers.

Source: SPIVA Statistics and Reports

Image: Unsplash/Ishan-seefromthesky

Subscribe to Our Newsletter

Our free newsletter keeps you up to date on investment topics. Your data will be kept confidential at all times.

The provisions of our privacy policy apply.

Risk Warning – With investment comes risk. The value of your investment can go down as well as up and you may get back less than you invest. Past performance or future projections are not indicative of future performance. We do not provide any investment, legal and/or tax advice. If this website contains information regarding capital markets, financial instruments and/or other topics relevant for investments of assets, the exclusive purpose of this information is to give general guidance on investment management services provided by members of our group. Please note our Risk Warning and the Website Terms.

 

Are you ready to invest more intelligently?

Join over 100,000 subscribers to keep up to date with our investment insights. Be the first to know about new features, downloadable guides, as well as our regular webinars.

Adam circular photo turquoise
Adam French
CO-FOUNDER & DIRECTOR
Adam spent the last 8 years working in London in the financial services industry. As Executive Director of Commodities Trading at Goldman Sachs, he was responsible for the Commodities Structured Products franchise. Prior to this, he worked in Derivatives Trading where he was responsible for electronic trading for private clients in fixed income, currencies and commodities products. Adam studied Business Mathematics and Statistics at the London School of Economics.