Stock Picking is Almost Always a Losing Game

Investing
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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.

User Generated Content Disclosure: Responses are not provided or commissioned by the bank advertiser. Responses have not been reviewed, approved or otherwise endorsed by the bank advertiser. It is not the bank advertiser’s responsibility to ensure all posts and/or questions are answered.

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Rk
Guest
Rk

Jacob, I am new to your blog, and educating myself about investments. I have read multiple articles that say pick ‘low expense index ETF fund’ (including from Warren Buffett). 1. But where do I begin to find ‘low expense index ETF’ . I read your wonderful reviews of Betterment and Wealthfront and very interested in them – but without signing up for either of those, if I want to pick ‘low expense index etf’ where do I begin ? Google search didn’t throw good resources. I guess I can pick the ones that are used by Wealthfront or Betterment anyways.… Read more »

LB
Guest
LB

Great post, Jacob. Funny how well you explain the efficient market hypothesis compared to some “professors” I’ve heard speak. I think your sentiment is also dead on.

Syed
Guest
Syed

Very good post Jacob. Of course there will be people out there who make money by stock picking, for the same reason a broken clock is right twice a day. Some will get lucky but most will not. Letting it ride with a diversified portfolio of index funds will almost guarantee you great returns in the long run.

Sam
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Sam

This is one of the most brilliantly composed arguments against individual stock-picking I’ve ever read. I sincerely appreciate you explaining this to me in layman’s terms. I started investing when I was in my early teens. The swings of the market, with small investment amounts, just made it too difficult and I eventually stopped. Then, came student loans and debt. Ugh! Finally, I’m back with a little cash flow. I’ve chosen to pick a few select stocks of companies I follow obsessively. These are companies like Apple, Google, and Tesla. Their products are aspirational — ones that I seek or… Read more »

Allan
Guest
Allan

Hi Jacob, great post! I agree with what you said. No one can predict the future. When there is someone telling you to buy, there is always someone telling you to sell and both seem to have great and reasonable reasons to convince you. It would be fun to track what the so-called gurus are praising and publish their results. I’m sure it would make them look very bad. Index funds investing is or could be a better approach than individual stock picking for most of us. Even Warren Buffett highly suggest everybody should do that. But for some folks… Read more »

Gabe
Guest
Gabe

I just couldn’t help but add a comment… Cash cow cites various studies that have been academically approved and scrubbed showing that, over the long term, it is nearly IMPOSSIBLE to beat the market by picking individual stocks or choosing an actively managed mutual fund. Very few in the academic world even try arguing these points anymore… BUT… many individuals/bloggers proceed to comment thinking they are the special one, the smart one, they have the stock picking super power… They invest in dividend paying stocks, they search for value stocks that aren’t priced correctly, etc. The list could go on… Read more »

Grayson
Guest
Grayson

I don’t pick stocks as I don’t have the patience for it. While my main investing form is ETFs and mutual funds, I will start picking stocks for dividends. That is part of the dividend game, but I plan on picking, buying, and holding them.

Juan Refrito
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Juan Refrito

Great post. The other consequence of stock picking is it can (and more often than not does, at least among my friends) distract folks from focusing on things they actually CAN control — increasing their rate of savings, reducing their cost of living, arranging their finances in the most tax-effective way possible, etc. Stock pickers want to believe that they can regularly score a touchdown when they are likely better served playing good defense and not turning the ball over.

Wade
Guest
Wade

Advice that should be repeated and repeated.

People that can’t save/invest want to start. When they do, they often just jump in and start buying individual stocks or high priced mutual funds. Investing at high cost/high risk is better than not investing. As you progress, if you are interested, you realize that costs matter, selling on the way down is horribly bad, owning individual stocks is taking on too much risk.

Using simple, low cost index funds, having your asset allocation set correctly for your risk tolerance, staying the course. These are invaluable mantras. Thanks for the good information.

bericm
Guest
bericm

A great post and I agree with the overall thesis, one should not confuse “stock picking” with “investing”, but I take issue with leading people back to – what I call – the Industrial Financial Complex. I have been on this rant ever since I realised that mutual fund industry MER’s were beating my returns. Me, the sheeple, stood by with sub-1% returns over 17 years from a leading, forever-touted-by-the-media mutual fund invested for my daughters education. I want to beat high-priced mediocrity: In ’97 I built a model portfolio based on “Dow Dogs” methodology; I maintained that portfolio for… Read more »

Brian
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Brian

I would only invest in individual stocks if: a) I had index funds already in place at multiple asset classes, b) had a long-term perspective for the stock, c) could do so with money I could afford to lose – because it is so risky, and d) had no other financial obligations (like debt) to funnel the money.

Shannon
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Shannon

You are so true and I see this play out all the time. I have clients who thought they did a great job picking stocks; however, the combined portfolio never outperformed the S&P 500. I have also had clients ask me to pick stocks and if I picked 5 and used the SAME exact methodology, 1 would perform well, 3 would just be okay and 1 would perform awful. There are thousands of industry professionals who want you to believe in stock picking; however, I have yet to see a compelling case.

The Dude
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The Dude

It is a rare bird, with a lot of time on his hands, who can trade stocks and win long term. I was introduced to Betterment through this Blog and use them. I have held a few stocks for decades like Citibank, Marriott, McDonalds which have done well with dividends reinvested. My $5,000 in Marriott, before you were born, is now $120,000. I am about done with individual stocks and will sell a couple today based on this column. I don’t feel like paying capital gains on $115,000, however. But now with tax efficient ETFs – it is really easy… Read more »

Kasia
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Kasia

I don’t think there’s anything wrong with investing in individual stocks as long as it’s as a long term investment (5+ years) and the stocks are in companies that have low debt, high assets and good income. Problems arise when the average investor wants to get rich quick through trading in start ups or companies that may or may not succeed on the market. Chances are they’re going to lose. After all trading is just ‘glorified’ gambling, and a way for stockbrokers to earn their keep – fewer trades means less income for them. Just like anything the news should… Read more »

Income Surfer
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Income Surfer

Index investing is certainly better for the “average” investor……but this is Lake Wobegon……and none of us are “average” (sarcasm).
-Bryan