Why Picking Individual Stocks Doesn’t Work
$100 bills don’t lie around on the street very long.
Most fund managers underperform their benchmark. Each day, the global financial markets process millions of trades worth hundreds of billions of dollars. These trades reflect the viewpoints of buyers and sellers who are investing their capital. By using these trades as inputs, the market can function as a powerful information-processing mechanism, aggregating vast amounts of dispersed information into prices and driving them toward fair value. Investors who attempt to outguess prices are pitting their knowledge against the collective wisdom of all market participants.
Mutual fund industry performance offers one test of the market’s pricing power. If markets do not effectively incorporate information into stock prices, then opportunities may arise for professional managers to identify pricing “mistakes” and convert them into higher returns. In this scenario, we might expect to see many mutual funds outperforming benchmarks. But the evidence suggests otherwise.
Investors may be surprised by how many mutual funds disappear over time. Less than half of the equity and fixed-income funds survived after 20 years. The evidence suggests that only a low percentage of funds in the original sample were “winners”—defined as those that both survived and outperformed benchmarks.
Some fund managers might be better than others, but track records alone may not provide enough insight to identify management skill. Stock and bond returns contain a lot of noise, and impressive track records may result from good luck. The assumption that strong past performance will continue often proves faulty, leaving many investors disappointed.
The chart below shows return difference between fund managers and their benchmark. The obvious takeaway is that most managers underperform their benchmark by 0.50% to 2.50%. The surprising takeaway is that the best managers only beat their benchmark by ~0.50%.
1. Only 20% of managers outperform their benchmark
2. Outperforming managers add around 0.50% of extra return
3. The fee difference between a passive vs. active fund in Canada is 1.29%
Despite the evidence, many investors continue searching for winning mutual funds / individual stocks and look to past performance as the main criterion for evaluating future potential. This leads to inconsistent performance, high fees, and tax inefficiency.
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Q: Is it hard to beat the stock market by picking individual stocks?
A: Yes, it is generally considered difficult to consistently beat the market by picking individual stocks. Here are a few reasons why:
Efficient Market Hypothesis: The efficient market hypothesis suggests that stock prices already reflect all available information, making it challenging to consistently identify undervalued or overvalued stocks. In an efficient market, it becomes difficult to gain a sustainable advantage and consistently outperform the overall market.
Information and Competition: Markets are highly competitive, with numerous professional investors and institutions analyzing stocks and seeking profitable opportunities. Access to information is widespread, and any new information that could impact stock prices is quickly reflected in the market. It is challenging for individual investors to have an informational edge over other market participants.
Behavioural Biases: Individual investors can be prone to behavioral biases that can lead to irrational decision-making. Emotions such as fear and greed can influence stock selection and timing, often resulting in suboptimal investment outcomes. Emotional biases can cloud judgment and make it difficult to consistently make objective and rational investment decisions.
Lack of Diversification: Picking individual stocks exposes investors to company-specific risks. Even if one stock performs well, a concentrated portfolio increases the potential for significant losses if that stock underperforms or faces financial difficulties. Diversification across different stocks and asset classes helps manage risk and reduces the impact of individual stock performance.
Time and Skill Requirements: Successful stock picking requires significant time and effort devoted to research, analysis, and monitoring. It necessitates a deep understanding of company financials, industry dynamics, and macroeconomic factors. The skill and expertise needed to consistently pick winning stocks are beyond the reach of many individual investors.
While there are instances where individual investors have achieved notable success in picking stocks, it is often difficult to replicate such outcomes consistently over the long term.
Many studies have shown that, on average, professional fund managers and individual investors who engage in active stock picking tend to underperform the broader market over extended periods.
For most investors, a more prudent approach is to focus on diversification, asset allocation, and adopting a long-term investment strategy. Passive investing through index funds or exchange-traded funds (ETFs) that provide broad market exposure is a popular alternative.
Source material and text taken from: Don’t Bother Trying to Pick Stocks
