There’s a lot of investment advice out there. Much of it has to do with building an investment portfolio by picking individual stocks. Most of the advice makes stock-picking sound fun, easy, profitable and generally pretty badass.
Today I want to present some simple facts that will help you decide whether trying to pick stocks is actually the right way for you to invest.
Some quick terminology
Before we get into the data, a quick terminology lesson.
An index is simply a defined selection of securities (e.g. stocks, bonds, etc.). A common index is the S&P 500, which is the set of stocks representing the largest US companies. There are also indices representing the entire US stock market, the entire US bond market, the entire international stock market, and almost any other portion of the market you can imagine.
An index fund is a mutual fund that simply attempts to match a particular index.
An active fund, on the other hand, is a mutual fund run by a person or team of people who are trying to outperform the “market”. In other words, they are picking stocks, bonds, or whatever in an attempt to get a better rate of return than if they just invested in an index fund.
Active funds typically cost more, so for the cost to be worth it they would have to outperform their comparable indices.
A fund’s comparable index is called its benchmark. So an active fund’s goal is to outperform its benchmark.
Can active managers pick the right stocks?
The surprising fact is that, on the whole, these active managers, who have spent years accumulating expertise, are paid handsome salaries, and have access to boat-loads of information, still under-perform simple indices year after year. In other words, they are unsuccessful in picking stocks that perform better than the market as a whole.
Every year, the S&P Dow Jones Indices organization publishes a series of reports analyzing this exact phenomenon. You can see the 2012 report here: SPIVA U.S. Year-End 2012.
The screenshot above is just a snippet of the information in this report. The numbers shown in the three right-most columns are the percentage of active funds that were outperformed by their benchmark. As you can see, in almost all cases the majority of active funds lost.
They do this analysis every year, for all different types of US stock funds, for all different types of US bond funds, and even for international funds. They analyze 1, 3 and 5 year performance periods.
Every year, the results are the same. Active funds keep losing.
The best funds don’t keep winning
The simple retort to the information above is that it only shows that the majority of funds lose to their benchmarks. There are still funds that are outperforming. So the simple conclusion is that there are some fund managers that are picking the right stocks and the rest just aren’t as good.
But this is my favorite part. The same organization also publishes another report called the Persistence Scorecard. You can see the most recent one here: Persistence Scorecard: December 2012.
Like the one above, this report has a ton of information in it and this screenshot only captures a small piece of it. But it is illuminating.
This report is comparing the top and bottom 50% of active funds over one 5-year period to the top and bottom 50% of active funds over the next 5-year period. So over the first 5-year period, there were 798 funds that fell into the top 50% in terms of performance.
The next column, titled “Top Half %”, is the good part. It shows the percent of the top-performing funds from the first period that remained in the top performing half over the second period. If there were legitimate skill being shown, this would likely be in the 70-90% range. In other words, most top performers from the first period would continue to be at the top in the second period. If it were a pure coin flip, then this number would be 50%, as half would continue to out-perform and half would subsequently under-perform.
The result is 40%. Less than half of the top managers from the first period remained a top performer in the second period. This is worse than pure chance.
The implication here is that there is no real skill being exhibited. It’s simply a matter of luck that some professional stock-pickers manage to outperform others or outperform the market over a given time period. And again, they publish these reports year after year and the results are always the same.
All of the above is fact. There is no theory, agenda or emotional appeal involved. It’s all the simple result of running the numbers.
Professional stock pickers can’t beat the market. They can’t even do it at the rate of pure chance. They actually lose out to a flip of a coin. And the ones that win over one period are more likely than not to lose over the next period.
So if they can’t do it, do you think it’s a good idea for you to try?
**Note: This doesn’t mean that you should avoid investing. There is a very attractive alternative to stock picking. It takes much less time, much less effort and will perform much better. It’s also a lot less glamorous, but we can’t have it all, can we?