Does stock-picking work?
- Stock-picking, the practice of selecting individual stocks to outperform the market, is far easier said than done.
- It is mathematically impossible for the average stock picker to beat a buy-and-hold investor in the same stocks.
- Compared to their benchmarks, most stocks return less and are far more volatile.
- The empirical evidence is overwhelming. Prudent long-term investing is a far more reliable approach than picking and trading stocks.
In any given period, some stocks go up, some down. It seems logical that if you can simply buy more of the stocks that go up than those that go down, you will get better results than the market. While the logic is sound, the realities of employing a strategy that relies on picking outperforming stocks make stock-picking a low probability affair.
Can you name anyone who has been successful at beating the market by a notable margin over a long period of time through their stock-picking prowess? Even for people like us who have been closely involved with markets over a few decades, the list is very short. It is tempting to think that picking stocks that will outperform will result in better returns, but the existence of a stock-picking guru is one of the financial market’s most enduring myths.
The lack of notable success should be enough to dissuade people from linking their financial success to stock-picking, but it often does not.
The lack of notable success should be enough to dissuade people from linking their financial success to stock-picking, but it often does not. Every year, a handful of stocks grab headlines for rising in value at an extreme rate. Those stocks typically have a storyline that is intriguing and seems obvious in retrospect.
Psychologists cite something called hindsight bias. It has three common forms: memory distortion, “I said it would happen,” foreseeability, “I knew it would happen,” and inevitability, “It had to happen.” We see all three frequently when it comes to stock performance. Google stock is a great example. So many people claim to have foreseen its strong performance, but its success is much easier to see in hindsight.
In 2002, Yahoo had the chance to buy Google for $1 billion. Management dragged its feet and by the time Yahoo was ready to act, the price had gone to $3 billion and they backed out of the deal. Most people react to that story by thinking Yahoo blew it. That looks true today because of what Google has become.
But, we have to remember that one cannot buy anything unless there is a seller on the other side of the transaction. While Yahoo could not foresee Google’s future, neither could Google! The company was willing to enter into a discussion to sell for $3 billion. It would not have done so if it thought it was worth more than that. The people running those companies may have had big dreams for their organizations, but they could not imagine what would become of the stock. Employing a strategy of trying to find the “next Google” is simply not one that is likely to succeed.
The mathematics of stock-picking
Even if you are not trying to find the next big winner, the mathematics of stock-picking puts the odds against you. Mathematically, it is impossible for the result of stock trading to exceed the return of a buy-and-hold investor in those same stocks over the same period because the traders incur more costs.
For instance, say you buy a stock at $10 and at some point, it is worth $20. The buy and hold investor has a return of $10, less the cost of buying and the cost of selling if they cash out at $20. Those trading in the stock during the same period will also garner a $10 increase in value, in the aggregate. Some will do better than others.
Let’s say the price goes to $12, then down to $9, then up to $17 before hitting $20. The first owner of the stock made $2, the second lost $3, the third made $8 (and possibly a TV appearance to talk about his exceptional success), and the last owner made $3. In the aggregate, these traders made the same cumulative $10 as the buy and hold investor ($2-$3+$8+$3). However, with each trade there was the cost of four sets of buys and sells. These extra costs lower the aggregate result.
This math holds true for every type of holding (not just stocks) in every period no matter how long or short, and regardless of whether the security appreciates or declines in value. More trading equals more costs.
These trading costs continue to accumulate, so over time, the typical result of traders gets worse and worse and those that do “win” at this game do so by less and less[i]. Plus, it is extremely difficult to determine if the outperformance was due to skill or just luck[ii]. In taxable accounts, the odds of achieving superior net returns are even worse as taxes can lower results by far more than all other costs.
Most individual stocks provide low returns and high volatility
To complicate matters, relatively few stocks typically power the market forward, as most stocks simply don’t perform all that well.. According to research by Heaton[iii], Bessembinder[iv] and others, four out of seven of the 26,000 stocks that traded on major U.S. exchanges from 1926 to 2015 did worse than U.S. Treasury bills, a reasonable proxy for cash. Bessembinder found that more than half of the market’s performance was attributable to just 83 of those 26,000 stocks and all of the market’s performance was attributable to just 4% of stocks!
To make things worse, even the most successful stocks reach their peaks via a very bumpy road.
To make things worse, even the most successful stocks reach their peaks via a very bumpy road. Even if you somehow made a great pick, continuing to hold the stock long enough to reap the reward could be difficult. Generally, the price volatility of individual stocks is on average roughly twice that of the market as a whole. There is evidence that while the market as a whole has not become more volatile, individual stocks have[v], and the best performers are far from immune from severe price declines.
A 2020 paper by Bessembinder studied shareholder wealth creation for all publicly-listed U.S. common stocks during each of the seven decades since 1950. Focusing just on the 100 most successful stocks in each decade, he finds substantial periods of horrific performance. Even during their most successful decade, “…shareholders experienced draw-downs that lasted an average of 10 months and involved an average loss of 32.5%. During the immediately preceding decade, draw-downs for these highly successful stocks lasted an average of 22 months and involved an average cumulative loss of 51.6%.”
A better approach than stock-picking
If we combine recency bias fueled by headlines of quick riches, hindsight bias reinforced by compelling storylines about these companies, and some FOMO, Fear Of Missing Out, the temptation to become a stock picker or worse an active stock trader can be overwhelming. That combination lured many people into day-trading tech stocks in the late 1990s and early 2000s and has reappeared recently with the advent of low-cost trading apps in the wake of COVID.
Despite the slick software touted to the masses by brokerage firms, individuals do not have anywhere near similar tools or insight as the professional investors. Professionals are very smart, very well-funded, are in it full time, and have significant resources supporting their efforts to beat the market. Yet, most still fail to add value through stock-picking. The odds are simply stacked against succeeding in this way.
Even Artificial Intelligence (AI) has not found a way around these odds. The small and ever-changing roster of outperforming stocks have been too much for AI to predict. A stock-picking exchange traded fund powered by IBM’s Watson hit the market in 2017. Since its inception through July of 2023, the fund has returned less than half the Russell 3000 index and less than a quarter of the S&P Technology Sector Select Index[vi].
If we accept the math of higher trading costs, the low numbers of strong performing stocks, the higher volatility of individual stocks and the psychology that accompanies such a bumpy road, these realities can boost our odds of taking a more prudent, reliable approach. Being broadly diversified and holding a portfolio that aligns with your goals is not easy by any means. The volatility of a broad market-wide holding is still significant even if it is half that of the typical individual stock, but the results of a prudent, long-term approach speaks for itself and does not require forecasting corporate earnings, the economy, markets, or political winds. You need not ingest news or other noise. If your goals are reasonable, and you are diversified, patient and disciplined, you are much more likely to succeed and far less likely to fail.
Additional Reading on moisandfitzgerald.com
[ii] “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” Fama, French 2010
[iii] “Why Indexing Works”, Heaton, Polson, & Witte, 2017
[iv] “Do stocks outperform Treasury bills?” Bessembinder, 2018
[v] “Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk”, Campbell, Lettau, Malkiel & Xu, 2020
[vi] Yahoo Finance
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