By |Published On: December 2nd, 2020|Categories: Factor Investing, Investor Education, Key Research, Behavioral Finance|

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:

The Stock-Picker’s Empirical Problem:

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:

Good luck!

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About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.

Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).

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