A stock market survival course: Part 2
Tuesday, December 04, 2018
This is the second article of a five-part survival course designed to give you essential information you need to succeed as an investor in the stock market. None of it is mere opinion.
Everything stated in these articles is backed by research conducted by well-known economists and published in leading journals of economics and finance. Each article can be read in 10 to 15 minutes.
The first article summarized the generally poor stock market performance of individual investors and explained why: most investors begin to invest with an inadequate understanding of the market, which leads to bad investment decisions and investment returns that underperform the market average by more than 60 percent.
This second article explains why stock-picking itself is a bad idea no matter who’s doing the picking.
Buying "Hot Stocks"
Many investors buy stocks because they’re “hot,” or, more accurately, because some third party says so. Stock brokers, friends and financial news publications, both online and print regularly make urgent buy recommendations for individual stocks.
And we all know someone who bought some obscure startup early on that turned out to be Apple, Google or Microsoft. So it’s tempting to follow the tip and buy “tomorrow’s Amazon.” Many investors build their portfolios this way.
There are several reasons why this is a bad idea, but here’s the most important reason: investors are terrible stock-pickers. Barber and Odean, the two University of California economists quoted in the first article of this investor’s survival course, made a five-year study of 66,465 accounts held in a large discount brokerage.
They determined that investors who traded individual stocks actively underperformed investors who bought and held by about a third. And the more often they bought and sold, the worse the outcomes. Barber and Odean put it succinctly in the title of The Journal of Finance article stating their results: “Trading is Hazardous to Your Wealth.”
Creating a winning portfolio — one that comes close to matching a benchmark like the S&P 500 — isn’t easy for professionals either.
Researchers at the Cass Business School at the City University of London devised a program that picked a portfolio of stocks at random — basically, the digital approximation of monkeys picking stocks by throwing darts at a stock page. What they found was that these randomly selected portfolios consistently outperformed active fund managers’ portfolios.
Unlike the results of individual investors, the difference between the results of active management and a benchmark weren’t considerable; another extensive study, by Novel Prize-winning economist Eugene Fama and his colleague Kenneth French, concluded that many fund managers did narrowly beat the benchmarks before management fees were deducted.
But after the deduction of fees, almost all of these professionals underperformed the benchmark. They further determined that while in a given year some investment managers outperformed, their number is about what you’d expect in a random distribution of returns.
Superior stock-picking, they conclude, isn’t skill, but luck. This, by the way, isn’t a universally agreed-upon conclusion. But it’s a conclusion held by most economists. Whether or not you believe that outperforming the market is at least theoretically possible, it is an inarguable fact that in any given year most fund-managers underperform. According to analyst Mark Hulbert writing in MarketWatch, in a given year only about 1 in 20 fund managers beat the overall return of the market.
A Standard and Poor’s study, published annually, comes to similarly unfavorable conclusions regarding fund managers’ persistence — the ability to outperform the market over time. Although a few managers outperform the market every year: “Out of 563 domestic equity funds that were in the top quartile as of September 2015, only 6.39% managed to stay in the top quartile at the end of September 2017.”
Individual investors underperform stock market benchmarks by wide margins. Professionals do better, and a number do narrowly outperform the market before management fees are deducted.
Once management fees are included, about 95 percent fail to match the return of the index. The 5 percent that do outperform in a given year are unable to outperform the market over time. This has led to a number of economists concluding that stock picking isn’t a skill at all; it’s luck.
In the upcoming third article in this five-part stock market survival course, I’ll begin proposing portfolio strategies to improve your results — to do better, in fact, than most professional investors.
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