UNIVERSITY of California finance professors Brad Barber and Terrance Odean published a research paper on investor behavior in early 2000. The results weren’t pretty. By their reckoning, individual investors lagged the overall market by an average of almost four percentage points a year. The culprit: the costs involved in trading individual stocks.
It isn’t just individuals who struggle with stock-picking. Professional money managers, on average, also trail behind the overall market. Over the past five years, S&P Global calculates that just 16% of mutual fund managers who attempted to beat the Standard & Poor’s 500-stock index actually succeeded. In other words, you would have had better luck—much better luck—guessing on a coin flip.
It is research like this that provides such strong support for index funds—that is, funds that simply buy and hold large baskets of stocks, instead of attempting to pick and choose and trading in and out.
It’s perhaps understandable that casual investors have a hard time picking winning stocks. But why do professional investors also have such trouble? Why is stock-picking such an uphill battle? Consider the recent sorry history of Facebook’s stock.
The drama began Saturday, March 17, when The New York Times published a damaging story about the company, revealing that well-connected political consultants had improperly acquired personal data on more than 50 million Americans from Facebook. Worse still, they had been using this data to influence our elections, including the 2016 presidential election. And there was evidence that the consultants still had the data, despite pledging years ago that they had deleted it. The fallout from this story has been extensive: Congress has demanded an investigation, investors have filed class action lawsuits and Facebook’s chief information security officer abruptly resigned.
In the wake of all this, the company’s stock suffered a double-digit loss. How does this explain why stock-picking is a losing proposition, even for professional investors? The answer: Despite all of Wall Street’s resources, none of the three major branches of investment analysis could have predicted recent events. Consider how each type of analyst viewed Facebook prior to the Times’s revelation:
In other words, Wall Street employs a large and diverse army of analysts, yet none of them predicted the recent price drop. It isn’t their fault; No one could have. No one—save for a few journalists—knew what was coming. And that’s precisely the problem with stock-picking. No matter how much time and energy one devotes to analyzing a stock, there’s just no way to predict these sorts of random and frequently occurring events.
Does this mean no one could possibly succeed at picking stocks? There are indeed stock-pickers with exceptional ability. But it’s also exceptionally difficult to find them, because they’re such a minority—and just because they have picked well in the past doesn’t mean they’ll continue to beat the market. The upshot: As tempting as it is to place a wager on one company or another, I think the best path to wealth is to stick with a set of simple, broad-market index funds in an allocation that fits your stage in life.
To be sure, index funds aren’t perfect either. In fact, they buy as many poorly performing stocks as human stock-pickers. But because they buy a small slice of every stock, and hold them through thick and thin, the impact is muted when any single company falls out of bed—and they always have a stake in the market’s big winners.
Adam M. Grossman’s previous blogs include Eye on the Ball, Pouring Cold Water and Tax Time Robbery. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.