Frequent visitors to our blog will tell you that we know nothing about stock picking. They’re right. In fact, we are convinced that it is just about impossible to consistently outperform a given index by trying to choose the best stocks. Of course, fund managers will tell you otherwise. It is their job, after all, to convince you that money invested with them is much more likely to grow at rates consistent with your goals.
Let’s have a look at a recent study from J.P. Morgan to show you why that isn’t likely to happen, and to demonstrate how diversification could be the right alternative. The study shows the returns of individual securities within the Russell 3000 Index, compared to the overall index between 1980 and 2014. The Russell Index contains the 3,000 largest US companies or around 98 percent of the market capitalisation on Wall Street. The report takes into account securities that were taken over or that went bankrupt. The results are sobering:
In short, there are far more underperformers than outperformers. The above results can be seen in the following graph:
Mutual fund managers Longboard have also studied the Russell 3000 Index and have produced results which further demonstrate just how hard stock picking is. Their research finds that from 1983 to 2006 just 25 percent of shares were ‘responsible for all of the market’s gains’2
This means that a stock picker would need to be right 3 times out of 4 just to stay in line with the index. The typical response from active fund managers is that it is all about timing. The job of the manager is to judge not only what to trade, but when. Rather than simply buying and holding, many active managers try to predict when securities are over- or undervalued, moving in and out of positions to avoid bear markets and profit from any subsequent bull rally.
This adds another layer of complexity to stock picking decisions, making the chances of being right 75 times in 100 even harder – because the manager is consistently required to ‘call tops’ and ‘pick bottoms.’ As the stock market adage goes, ‘only monkey’s pick bottoms’! More importantly, the unseen costs associated with such a strategy, the bid/offer spread for example, often increase management fees which can have a substantial detrimental impact on your overall returns, as shown in the chart on the right3.
Given the evidence we started with – that the vast majority of professional fund managers fail to outperform the index – individual investors really don’t stand much chance at being more successful at stock-picking. At Scalable Capital, we believe that the correct strategy is based on a globally diversified investment using passive instruments, combined with minimal fees. We do not try to predict or judge the prices of individual stocks; instead, we focus on a data-driven, risk-based division of capital across broad asset classes. Risk is more predictable than return and that is where we put our focus (read more about our evidence-based investing strategy). Ultimately we believe that risk is the currency an investor uses to pay for return. Try our dynamic risk management approach and find out for yourself just how superior it is to stock-picking.
Image: Jared Erondu/ Unsplash.com
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