Pick Stocks Yourself, or Leave It to the Professionals? The Answer Will Surprise You …
10 min read
Are you gambling or investing?
Stock picking has often been thought of as something that is best left to the professionals, but recently it has gained popularity amongst DIYers. Even the infamous Dave Portnoy of Barstool Sports fame has found himself more than dabbling in the realm of picking stocks. His inspiration to a new generation of investors to take up trading seems innocent on its surface, yet it blurs the lines between investing and gambling.
Fundamentally, it seems straightforward: pick a stock that you are familiar with, and surely if you like it, then other people must too. However, any investment without proper due diligence becomes a roll of the dice. Sure, play around and gamble with a couple of grand and buy Lululemon because you love their ABC pants. For a laugh, go to their website and look up what the "ABC" stands for. You may even find yourself laughing harder at the price. If investing a small amount gives you the same thrill as taking the money line on the Detroit Lions, so be it. Understand that this message is directed at your serious money. Your ‘pay for the kid's college, retire before I'm 60, and stay retired’ - money. After all, the stakes are a bit higher, as so should be your due diligence.
Okay, so you’re an investor, and we’re talking about your ‘serious money.’
So how do amateur money managers tend to fair? And by an amateur, I'm referring to an investor who doesn't manage investments as their primary means of employment.
I worked for three different firms in my career that allowed self-directed investing. I, unfortunately, have seen first-hand many more folks strike out than hit a home run. This is partially due to this group of investors attempting to time the market (more on that here) and partly through poor stock picking. That being said, we will set the record straight and arm you with information to transform yourself from a gambler to an investor.
“Investing is a zero-sum game. To buy a stock, someone else has to be selling. You are betting you know the company better than the person that is selling it to you.”
Let's break down why investors, especially those focused on creating sustainable wealth, should invest differently (beware, this next part concerns the investors who do an obscene amount of analysis, listen to conference calls after earnings reports, read 10k reports, and otherwise sit in front of their screen all day long)… indeed the majority of these guys beat the market, right? Yet, the fact is that even the bulk of the professionals can't consistently "beat the market," much less the amateurs…. Hold up, hold up – so if you're saying the amateur stock pickers can't do it, and the professional analysts can't consistently do it – then what is the solution?
Before diving in, I'd like the thread-in a casual reminder. I'm an independent advisor with no obligation to any fund company or type of strategy. I don't get paid more or less to recommend any particular investment over another. These are my evidence-based beliefs and are in no way whatsoever influenced by my compensation.
**Cue suspenseful music as I attempt to pull back the proverbial industry curtain and show you the real facts and figures behind picking stocks.
Active vs. Passive
In no way would I consider myself smarter than an Ivy-league educated Wall Street Analyst. Everything we are about to cover will be deep-rooted in statistical evidence and refutes why even the majority of these "stock-picking experts" can't beat the market. There are a few possible reasons for this, but if you are one of those folks who believe the market is 'rigged,' then it's time to get on the right side of it.
Let's first break down two primary ways to invest in the stock market:
Active Management – involves just that, actively managing your specific positions (i.e., buy Nike, sell Under Armor).
Passive Management - seeks to own certain parts of the market as a whole. For example, instead of trying to pick the best handful of large healthcare companies in the US, you could passively buy that entire industry. The idea here is the healthcare as a whole may have done well, but you just picked the wrong couple of companies and missed out on the gains of all the others. So the fundamental question being asked here is: does the reward of being right to outweigh the risk of being wrong? For most, not at all. I'll take being vaguely right over precisely wrong every single day of the week.
“Don’t look for the needle in the haystack. Buy the haystack.”
These stock-picking wizards certainly charge a fee to pick stocks, and if most of them can't beat their benchmark, why does active management even exist?
“It is difficult to get a man to understand something when his salary depends on his not understanding.”
Let’s talk facts.
As with anything in life, I'm of the mindset that if there's a fee for something, I damn well better be getting what I'm paying for. Or the value I receive should exceed the cost. Fortunately, the good folks over at SPIVA publish their US Year-End Scorecard, seeking to answer this for us. The S&P 500 is the industry standard and one of the best barometers of large US Stock Performance as it tracks the performance of the 500 largest companies in the United States. Over the last decade, 82% of these "pros" underperformed this benchmark. To say it another way, 82% of these funds did not justify their fee. Looking beyond the most recent decade, the proof is in the pudding. Time is not on the side of the professional stock-picker, with that number rising to an astounding 94% over the last 20 years.
Percentage of U.S. Equity Funds Underperforming Their Benchmarks
Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, 2020. Past performance is no guarantee of future results. Charts are provided for illustrative purposes.
But again, if this is really true, then why do these vehicles exist? Fortunately, the accessibility of information provided by the internet and the general public being better informed as a whole is changing this. Last year, passive investment vehicles (most ETFs & Index Funds) surpassed active (most Mutual Funds) in assets under management for the first time in history.
By its very definition, passive investing resolves that you will perform in line with the market. Some may consider this settling for average and mediocre performance. Paradoxically, settling for the average return of the market would have ensured you would've outperformed the average of the pros! Here are two great quotes that frankly say it better than I ever could:
“Building a portfolio around index funds isn’t really settling for the average. It’s just refusing to believe in magic.”
“It’s true that when you buy an index fund, you give up the chance to boast at the golf course that you picked the best performing stock or mutual fund. That’s why some critics claim that indexing relegates your results to mediocrity. In fact, you are virtually guaranteed to do better than average. It’s like going out on the golf course and shooting every round at par. How many golfers can do better than that? Index funds provide a simple, low-cost solution to your investing problems.”
Sure, that's over the long run, but what if I just pick the best manager each year?
“When it comes to fund managers and market strategists, this year’s hero usually turns into next year’s zero.”
Percentage of U.S. Equity Funds Underperforming Benchmarks (Rolling Three-Year Returns)
Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, 2020. Past performance is no guarantee of future results. Charts are provided for illustrative purposes.
As reflected in the graph above, consistently picking the hot hand each year is a losing proposition. In fact, you might even argue that hiring an advisor to pick the best manager each year for you has a lower probability of success than picking the best stock each year. What you end up with within that scenario is a manager, managing managers. Sound expensive and unnecessarily redundant? Yes.
The resounding truth is, the active vs. passive debate ends with the active managers coming up shorter than me in 9th grade. Yeah, so I was a late bloomer, but you making a change to your portfolio's equity portion doesn't have to be. The sooner you get on the right side of these statistics, the better off you will be.
Don't get me started on the lack of transparency, taxes, minimum investment thresholds, liquidity, expense ratios, transaction costs, brokerage commissions, market impact cost, spread cost, tax cost, cash drag, and soft-dollar arrangements - that is all a story for another time, but might be an indication of why it's so dang tough for mutual funds to "beat the market." Each one of those costs, whether direct or indirect, is just another hurdle for a mutual fund manager to have to leap over in pursuit of beating the market.
Key takeaway …
Want to know how to beat around 9 out of 10 professional money managers over the last couple of decades? Buy their specific benchmarked or segment of the market they are attempting to outperform as a whole. Stop gambling and start investing. It doesn't matter if you are gambling yourself or gambling alongside the best of the best - the market is the great equalizer, and the house always wins. It's time to stop gambling, start investing and become the house.
P.S., There are some situations where active management may make sense. Suppose you are investing for a specific purpose other than market participation (i.e., If you are more focused on current income, then the ability to kick out stocks or bonds with unsavory yields may justify active management, as that goal may supersede total return over time. That said, taxes and your specific risk tolerance can also play role in this decision).
P.P.S., We believe that passive vehicles allocated according to an individual investor's personal goals and risk tolerance exists as the best way to accumulate long-term wealth. While the S&P 500 was used as an example within this article, it may not even make sense for some investors, based on their customized plan.
Don't just take my word for it.
Below is a roundup of industry thought leaders and their active vs. passive debate position.
“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”
“Santa Claus and the Easter Bunny should take a few pointers from the mutual-fund industry. All three are trying to pull off elaborate hoaxes. But while Santa and the bunny suffer the derision of eight-year-olds everywhere, actively-managed stock funds still have an ardent following among otherwise clear-thinking adults. This continued loyalty amazes me. Reams of statistics prove that most of the fund industry’s stock pickers fail to beat the market.”
“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
“The 21st century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners — neither he nor his ‘helpers’ can do that — but should rather be to own a cross-section of businesses that in the aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.”
“The long-term data repeatedly document that investors would benefit by switching from active performance investing to low-cost indexing.””
“It’s fun to play around...it’s human nature to try to select the right horse...(But) for the average person, I’m more of an indexer...The predictability is so high...For 10, 15, 20 years you’ll be in the 85th percentile of performance. Why would you screw it up?”
“The difficulty lies, not in the new ideas, but in escaping from the old ones.”
