A Short Research Library Outlining Why Traditional Stock Picking is Challenging

There are no “right” answers when it comes to financial markets. There are generally trade-offs to all decisions. For example, stocking picking can be incredible and crush every other investment approach; but stock picking can also be horrible. Similarly, 100% systematic investing, “quantamental” investing, voodoo investing — and everything in between — can all be incredible and they can be horrible.

And while we can never say that one approach always dominates another approach, we can make general arguments for and against different approaches based on empirical evidence and common sense. For example, on average, voodoo investing is less repeatable and transparent than evidence-based systematic approaches.⁽¹⁾

What follows is a short summary of research that Jack and I put together that outlines why traditional discretionary stock-picking, on average, is a poor idea.⁽²⁾ Sure you can win, but the odds aren’t in your favor. If you are exploring stock picking, or have clients who claim to be Warren Buffett, we recommend you sit down and review the materials discussed below.

If you still walk away with a desire to play the game, go for it. As a recovering member of the stock-picking anonymous club, I empathize with those who are confident in their ability to be “the one” that bucks the trend. I just don’t think it is a great idea.

We’ll break this short library of articles/research into 3 sections:

1. The challenge of individual buy and hold stock return distributions: most stocks fail, miserably.
2. The empirical evidence outlining the performance of active stock-pickers: the vast majority add no value, only noise and costs.
3. The ability for systems to replicate (with less bias!) the capabilities of active stock-pickers: machines can do it cheaper and more efficiently.

The Individual Stock Return Distribution Problem:

• Do stocks outperform treasury bills?
  • Almost all the stock market gains come from a small subset of stocks, so stock picking is extremely difficult!! A crazy statistic in this paper: most stocks have worse returns (lifetime buy and hold performance) than holding cash!
  • Important critiques of this paper are here and here
• The Risk of Owning an Individual Stock
  • Key statistic: 73% of individual stocks experience a drawdown of 50%+ over their lifetime.
• One Way to Beat the Market. Be Different!
  • Randomly selecting small portfolios of stocks is a great way to lose relative to a broad-based index.

The Stock-Picker’s Empirical Problem:

• Luck versus Skill in the Cross-Section of Mutual Fund Returns
  • Finding skill among stock-pickers is not impossible, however, the costs of entry are so high that investors rarely win after fees.
• Active Management in Mostly Efficient Markets
  • Similar to above, it is possible to find successful active stock-pickers, but the chances are bleak.
• On Persistence in Mutual Fund Performance
  • Maybe you find a winning stock picker, but did they get there on purpose? Unlikely. And can they continue to win? Unlikely.
• SPIVA Scorecards
  • If you’re an active stock picker, this is a great way to feel depressed about your prospects of success.

The Stock-Picker’s Replication Problem:

• Superstar Investors
  • Finding skill among stock-pickers is not impossible, however, the costs of entry are so high that investors rarely win after fees.
  • A fun article that ties back to the paper above and adds some flavor.
• Buffett’s Alpha
  • Even the great Warren Buffett can be replicated, in many respects, via a computer algorithm.

Hrmm. Maybe we Simply Drop Everything and Buy Market-Cap Weighted Indexes for Free?

Not necessarily. The world is full of trade-offs and nothing is ever free. We must always face expected benefits and expected costs.

Here is a basic workflow of how I would consider this question if asked:

1. Currently, market-cap passive funds follow a process that deliver an extremely low cost exposure to a portfolio of relatively expensive, mega-cap stocks, which have done very well, recently.
2. However, historically, portfolios of relatively expensive and extremely large stocks (i.e., passive indexes in their current form) deliver lower returns and lower volatility than portfolios of stocks that are cheaper, have high momentum, and/or are outside of the mega-cap market.
3. If your financial goal over the next 20 years is to have a decent return with lower volatility — and you value the ability to closely track the markets on a day-to-day basis — passive market-cap Indexes are great.
4. If your financial goal over the next 20 years is to have higher returns — and you are willing to take on more volatile short-run performance that deviates from the general markets — passive indexes may not be the best solution.
5. Of course, costs always matter. So if we want to go down the #4 route and seek the higher return, higher volatility objective, we’ll need to focus on strategies that deliver the desired exposures affordably and efficiently. Otherwise, maybe #3 isn’t a bad option.

Market-cap indexes are not a panacea and active investing is not necessarily a bad idea, but high costs can ruin almost any investment party. Moreover, just like we should avoid pitches that suggest there is an active strategy that can beat the market, consistently, we should avoid any sales pitch that 1) quote’s Bill Sharpe for social proof purposes and 2) makes the following claim:⁽³⁾

Check this out: We have this awesome market-cap weighted passive index investment strategy that earns higher returns with lower risk than these loser active strategies, comes at ~zero cost, and you can buy it in infinite supply without market impacts. What could go wrong?

If one would like to explore the various arguments of passive versus active in more detail, we recommend you read the following deep dive on the topic via Prof. Geoff Warren:

• Is Active Investing Doomed as a Negative Sum Game?

Good luck!