Why Stock Picking Is Hard
When I began actively buying and selling stocks in the 1980s, I believed I was good at picking outperformers. I made outsized returns on companies like Nike and Nature’s Bounty, which I took as confirmation of my abilities. Or was it just beginner’s luck?
Aristotle once said the more you know about something, the more you realize what you don’t know. After a few years working on Wall Street, I learned beating the market is hard for experienced professionals, let alone individuals, and the idea of having some special ability was a bit naïve.
Today I don’t own individual stocks, even though I sometimes have the temptation, and usually recommend the same to clients. Here’s why.
The odds of picking winning stocks are against you
The idea of getting rich investing early in the next Apple or Microsoft can be seductive. But what most investors don’t realize is that while the overall stock market tends to rise over the long term, the odds of picking individual stocks that outperform the market are just awful.
That’s because the market’s growth is largely driven by a small number of “superstocks” with massive returns that more than compensate for the large number of losers and underperformers.
In one eye-opening study, economist Hendrik Bessembinder analyzed the returns of nearly 26,000 stocks that have traded in the U.S. from 1926 to 2016. Here’s what he found.
- 69% of stocks failed to keep up with the overall market’s returns
- Over half of all stocks lost money
- Approximately one third of stocks lost over 75% of their value
- Of the 31% of stocks that outperformed market, most outperformed by just a small margin
- Only 4% of stocks accounted for all the stock market’s wealth creation[i]
This last data point is the most striking. It means that if an investor’s portfolio missed the 4% of most profitable stocks, and instead invested in only the other 96%, he or she would have been better off in cash over the period.
Bessembinder found in subsequent research that the degree to which wealth creation is concentrated in relatively few firms has increased over time, implying that identifying winners is getting even harder. He also found that concentration is even more pronounced outside the U.S., where less than 1% of stocks accounted for all the market’s wealth creation.
One point of contention with this study is that it assumes an investor holds each stock for its lifetime, which most investors don’t do in practice. Good investors, like professional money managers, should be able to identify companies with superior prospects and trade them at attractive points in time to outperform the market. At least in theory, but that’s not what we see in practice.
Even professional investors have a hard time
Even professionals struggle to overcome these tough odds and match with the returns of the overall stock market. According to one annual study, 86% of professional fund managers fail to outperform their benchmark over a 10 year period.
Compare this to other professions. Imagine if your car got repaired only 1 out of every 5 times that you brought it to the mechanic. Or if 86% of all surgeries did not achieve their desired outcome. But this is the success rate of professional money managers who actively trade stocks to outperform that market.
What’s more, very few of the top fund managers remain on top. One study showed that among funds in the top quartile (25%) based on previous five-year returns, only 21% were ranked in the top quartile in the next five years. That’s fewer than can be predicted by chance, suggesting that outperformance among fund managers tends to be short-lived and largely a factor of luck.
Why the odds are so difficult to overcome
You may be wondering why even professional investors, who are highly educated, highly compensated, and armed with massive databases and powerful analytical tools, can’t overcome these odds. There are several reasons, as discussed by Larry Swedroe in his book “The Incredible Shrinking Alpha”.
First, there’s much less “dumb money” to exploit. It used to be that over 90% of trades were done by individuals, and less than 10% were done by institutional investors. Today those numbers are flipped, as individuals account for roughly 10% of trades, and institutions account for 90%. That means each time you buy or sell a stock today, a trader from Goldman Sachs or some hedge fund is likely on the other side of that trade.
Second, the average investor has gotten a lot more sophisticated. When people become better at an activity, the difference between the very best and average participant shrinks, a phenomenon known as the paradox of skill.
We see this paradox in sports like basketball, where players today are better athletes than years ago due to better training, diets, etc. Star players like Wilt Chamberlain could once average 50 points and 25 rebounds a game, yet the best players today average 30 points and 15 rebounds at best. Similarly, Wall St firms now attract top MBAs, PhDs, world class scientists and mathematicians, making the competition stiff and the task of outsmarting one another much more difficult than years ago.
Third, it’s much harder to have an informational advantage. I can recall early in my career when companies would share insights about news and earnings to select analysts and investors before releasing them to the public. It was also possible for motivated investors to obtain financial publications like Barron’s before they hit newsstands, providing an informational advantage they could trade on.
Those kinds of advantages no longer exist (legally anyway, just ask Martha Stewart) as new regulations require companies to release new information fairly and at the same time to everyone, and technological advancements like the internet have completely leveled the playing field when it comes to information availability.
As a result, even the most sophisticated investors have a difficult time finding an edge sufficient to outperform the market with any consistency.
What about Warren Buffet?
There are a handful of superstar investors who manage to defy the odds and outperform the market over long periods, like one of my own personal heroes, Warren Buffett. His holding company Berkshire Hathaway generated an annual return of 20.1% from 1965 to 2021 vs. 10.5% for the S&P 500. This nearly 10% outperformance, which finance people call “alpha,” is extraordinary by any measure.
Warren Buffet may not be a fair comparison, as he’s in a different league than most investors. He invests with leverage, has access to cheap capital, and sometimes gets involved directly with management, like when he guided Salomon Brothers out of crisis in the early 1990s.
Nevertheless, as extraordinary as Mr. Buffett’s success may be, it isn’t due to some unique gift for stock-picking as conventional wisdom suggests. Academics have essentially reversed-engineered his ability to outperform the market and have identified certain known and replicable strategies.
In one study that analyzed Mr. Buffett’s returns over 40 years, researchers identified a few specific factors that explain his outperformance. Many of these factors are head-smackingly obvious too, like focusing on “value” (companies that are cheap compared to their book value or earnings) and “high quality” (companies that are profitable, stable and growing).
To Mr. Buffett’s credit, he was steps ahead of the academics and capitalized on these factors well before they were published in the literature. Also to his credit, he has the patience and discipline to stick with his approach over multi-year stretches when it is underperforming, like in the late 1990s when he underperformed the market by over 30%.
In the past, a strategy of targeting factors like value and high quality involved a lot of work and was expensive to execute. The good news for investors is there’s been much innovation in personal finance in recent decades, and today these strategies, for the most part, can be replicated systematically through low-cost mutual funds and ETFs.
What to do instead
John Bogle, founder of index fund giant Vanguard, used to say “don’t look for the needle in the haystack. Just buy the haystack.” What he meant is rather than trying to pick the next Apple or Microsoft, most investors are better off owning the broad range of stocks in an investment like an index mutual fund. By owning the whole market, you’re guaranteed to own the superstocks that drive the overall market’s returns, while diversifying away the risks for which you’re not compensated.
Then, if you want to try and improve on that approach, and you believe that factors such as value and high quality will continue to be drivers of better performance, there are variety of investments that provide exposure to these factors while owning the “haystack.” This is the strategy we employ for most of our clients, which evidence suggests will give them the best odds of success over time.
Never say never
This is not to suggest everyone should avoid investing in individual stocks. For some people, owning a broadly diversified portfolio is not very exciting and doesn’t make for interesting cocktail conversations. Some people want lottery-like returns possible with picking stocks, and there’s nothing wrong with that objective if you understand the probabilities and are comfortable with the risks.
If you are one of these investors, my advice is to do it with a small portion of your assets (less than 10%), keep track of your results (winners as well as losers), and set realistic expectations. A few good stock picks can produce life-changing wealth, and hopefully luck will be on your side. But don’t be disappointed if the poor odds play out as they do for most investors who take this approach to growing their wealth.
[i] Bessembinder defines “wealth creation” as the accumulation in market value in excess of the value that would have been obtained if invested in one-month U.S. Treasury Bills.