Stock Picking is Almost Always a Losing Game

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Do you get tired of hearing other people talk about investing? For the most part, I can’t stand reading or listening to the mindless chatter.

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.

If you can learn to ignore it all and focus on the empirical research, you will outperform the vast majority of investors.

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 events. 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:

  1. There are mispriced securities that can be identified in advance
  2. 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. There are no guaranteed arbitrage opportunities in the financial markets.

Are you misinformed?

When you try to buy underpriced “winners” or sell overpriced “losers,” you must believe that the person on the other side of the trade is either 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 specific stocks. What are they basing these recommendations on? The only information they have is widely available to the public, for free (inside information is illegal).

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, and an army of Ph.D. quants who stare at numbers for 14 hours each day. Why do you think that 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 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 mutual fund 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 we 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:

Individual investors:

  1. Underperform standard benchmarks (e.g., a low cost index fund)
  2. Sell winning investments while holding losing investments (the “disposition effect”)
  3. Are heavily influenced by limited attention and past return performance in their purchase decisions
  4. Engage in naïve reinforcement learning by repeating past behaviors that coincided with pleasure while avoiding past behaviors that generated pain
  5. 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)

In summary:

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.

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 lesser known 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.

Summary

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.

The Take-Away

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.

  1. People are suckers who love a good story. Research and reason don’t sell products.  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.
  2. 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.

Editorial Disclaimer: The editorial content on this page is not provided by any of the companies mentioned, and has not been reviewed, approved or otherwise endorsed by any of these entities. Opinions expressed here are author’s alone.

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az
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az

Great post Jacob, people don’t want to read this for obvious reason. I love or loved trading, but the more I traded worse results would be. I ended up writing some algorithams that helped improving the results. At the end all my mutual funds accounts still perform better than all my stock picking accounts. With stock picking accounts I would have some winning periods, but than I would have a period where I would just get hammered. I should say, I’m profitable in all my accounts, but.. for stock picking giving the stress and amount of research I’ve done it’s… Read more »

AG
Guest
AG

I pick stocks and had about 23% annualized return for last 15 years. Market indexes is about 10% for last 15 years. My rate helps me achieve financial independence and 1% status. Each transaction of stock is intellectual decision against each other between buyer and seller, in which both buyer and seller think their own judgment superior to others. As Charlie Munger put, it is a parimutuel horse bet in stock market. In investment world, when your correct judgment not shared by majority, you get rich! -That is how value investor make money In layman’s term, value investing is spotting… Read more »

Woody
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Woody

After I lost almost 4k in amd stock. I start searching how to enrich myself.
Using your article, I started putting money into mutual funds instead. Thanks.

Sorrydude
Guest
Sorrydude

Woody, you should have stayed

LFOD
Guest
LFOD

I disagree that the market is efficient. Yes, the information to make the market efficient is available but most people, including the so called experts make decisions based on emotion not logic. It was as plain as the bald spot on my head that the market was over-valued in 2002 before the tech bubble burst but people were too caught up in the buying frenzy to use a little sense. It was equally easy to see that the market was under-valued after the selling stopped, but people were too frightened to get back in. It was only slightly less predictable… Read more »

Mark K.
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Mark K.

Interesting article. I’ve been looking at writing covered calls and puts to supplement dividend income and sweep interest. My research so far has been learning how to do better fundamental analysis. You’ve inspired me to look into whether any index ETFs are optionable.

Yuval Taylor
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Yuval Taylor

I don’t understand how it’s mathematically possible for every investor to underperform the market, if “the market” represents the aggregate of all stocks that are bought and sold. For every loser in a transaction, there has to be a winner. Some of those winners are those who profit from transaction costs and fees, but considering the heavy losses that both mutual fund managers and individual investors undergo, someone else has to be making some heavy gains. In fact, there have always been and always will be some individual investors who handily beat the market for over a decade; and there… Read more »

Anders
Guest
Anders

I disagree with this. If you put in the effort it’s completely possible to beat the market especially with all the information at your disposal. As an individual investor, you can develop your own niche and be quite successful. You’ll be under the radar and can get away with a lot more. For every winner there’s a loser in the stock market; however, it is possible to be a winner with the right work ethic and mentality. For most people, it is too much work. A serious investor is a lifelong learner who constantly refines and betters his method. That… Read more »

clay
Guest
clay

I am new to investing at age 60. Wish I had started earlier but can’t go back, only forward. I started with Betterment a year ago in July with a 30,000 investment. Added 2000 every month on a 66% stock 44% bond portfolio. At this time I have invested 52,000 and am up $600. Not exactly setting my retirement up with a 1.2 gain! The portfolio spent more time in negative territory than positive. Was the last year just a bad year for the investments Betterment picked for me? Not sure but at this time I don’t have a lot… Read more »

Master Nerd
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Master Nerd

Hey Jacob,

Great post! Regarding: “Invest in index ETFs that track small companies and those that are not publicized (value companies)” I’m fan of Betterment style investing (just recently we got Wealthsimple up here in Canada), but they certainly invest in more than just small-cap non-publicized companies, so I’m just wondering if you could give a couple specific examples of ETFs you had in mind? I’m still in the process of transitioning my portfolio from large blue chip companies into exclusively ETFs, so I’m always looking for ideas.

The Professor
Guest
The Professor

I largely agree with you. Something like 86% of mutual funds underperformed the S&P 500 last year. With respect to international equities, however, I disagree. Many emerging markets are not as efficient as that of the U.S., and strong fund managers are better able to outperform the respective indexes of those markets. I also tend to disagree with the premise that you need to be outsmarting the person on the other side of a trade. Sometimes, people are forced to sell a security because they need the money. Think back to 2009. Many people lost their jobs and thus pulled… Read more »

Brian
Guest
Brian

While I completely understand your view, and agree that its the right strategy for 99% of investors, I personally will continue to buy individual stocks. I don’t think its just a matter of being ‘right’ versus the other side of the trade being ‘wrong’, I think its simply a matter of time horizon. If I buy SBUX with the intention on holding it for 10+ years, and there person that is selling it only cares about the next 3-6 months, then I have the advantage. Short term prices movements mean little to me, but far more to the trader who… Read more »

Master Nerd
Guest
Master Nerd

So you’re saying that you’re one of the top 1% investors in the world? I totally agree that long time horizons will no doubt help you beat out the vast majority of individual investors, but the research seems to indicate you can still do better than that with ETFs. Assuming that the research correctly found that only 12 out of 500 S&P 500 stocks beat the overall index, how do you know that 40 years from now your stock picks will be part of that exclusive 12? I think what the research is really saying is that even if you… Read more »

Mark
Guest
Mark

I inherited 5K worth of mutual funds when my Grandmother died back in the late 90’s. At that time there was a promotion at our local computer store where I could get a good computer for cheap if I signed up for a online brokerage account. Heck yeah! I thought this is a breeze… get a new computer, cash out that lame mutual fund and pick my own winners. Guess what my first “pick” was?.. ENRON = Ouch. Then, I bought books, online advice, trading forums and even quit my job taking a 25K cut in salary so that I… Read more »