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Look Down—and Up

Adam M. Grossman

I WROTE ABOUT the perils of timing the market last Sunday. This week, I’ll address its close cousin: stock-picking.

These days, many people accept that stock-picking isn’t a great idea. Evidence shows that both professional and individual investors fare poorly, on average, when they choose individual stocks. But why exactly is that? How is it that indexes—which are simply lists of stocks—so frequently outpace the results of professional portfolio managers?

There’s more than one answer to this question. But recent data has highlighted a key explanation. In a 2021 study of professional portfolio managers, researchers found that fund managers are actually pretty successful at picking stocks. On average, in fact, they outperform with the stocks that they buy. Those stocks went on to outperform by more than a percentage point over the next year.

Instead, the problem is on the other side of the trade. When deciding which stocks to sell, portfolio managers often fare poorly—meaning they would have done more for their portfolio’s performance by simply selling a random selection of the stocks they own. That, on average, is what causes actively managed funds to underperform. Fund managers’ poor selling decisions more than offset their good buying decisions.

The study explored possible explanations for this phenomenon. Among them: Fund managers get scared when bad news impacts stocks in their portfolio. Every company, almost without exception, will go through difficult periods that weigh on its share price. In many—if not most—cases, companies recover from these rough periods and so, too, do their share price. The stocks may even outperform as the dark cloud passes. But in the middle of a crisis, when the news is bad, it can be hard to see the light at the end of the tunnel. That’s when portfolio managers tend to react poorly.

Consider this year’s most prominent example: Facebook parent Meta Platforms has seen its stock drop by nearly 40%, wiping out nearly $400 billion of market value. The problem: Apple recently implemented a set of privacy controls that limits Facebook’s ability to target advertising on iPhones. Google has announced it’ll follow suit with its Android platform. The impact has been noticeable. In its most recent quarter, Meta’s revenue and profits rose, but at a dampened rate. Compounding investors’ worries, Facebook also reported a decline in user engagement.

Imagine you were a mutual fund manager and owned Meta stock. What would you do? The easy option would be to sell it, take your lumps and reinvest the proceeds in a stock that looks like less of an uphill battle. That may or may not end up being the best decision, but it would be the easy one.

The alternative, of course, would be to hold onto the stock. But that would require having faith that it’ll recover within some reasonable period of time. I spoke with one investor last week who worried that it might take Facebook five years to rebuild its ad business. That strikes me as a long time, but right now, it’s anyone’s guess. That, in a nutshell, is why fund managers have such a hard time making good decisions when it comes to selling stocks.

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Further complicating matters: Share prices don’t rise and fall in response to just one issue. Investor sentiment, of course, plays a part in moving stock prices. But that’s not all. Corporate boards, management and shareholders all have levers they can, and do, employ to help move prices. These include:

  • Developing new products or acquiring product lines from other companies.
  • Spinning off less profitable products or business units.
  • Cutting costs, including layoffs and other types of corporate realignments.
  • Initiating a dividend or increasing it.
  • Initiating or adding to a share buyback program.
  • Selling real estate—sometimes accompanied by leasing the property back.
  • Settling a lawsuit or government inquiry.
  • At the extreme, replacing the CEO or putting the company up for sale.

Sometimes, it takes just one of these actions to spark a share price rally. Corporate managers are highly incentivized, via stock options, to do what they can to move their company’s share price higher.

Other times, this requires outside pressure from shareholders. Activist hedge funds often play this role. I’m not a fan of hedge funds. But they can play an important role in encouraging companies to take action they previously may have resisted. Carl Icahn, for example, was instrumental in Apple’s decision to initiate large-scale stock buybacks—a move the company initially fought. Icahn was also behind the 2014 push to separate PayPal from its former parent, eBay.

The upshot: The outlook for a company—and even the entire market—can look grim, especially if we focus on a single, worrisome issue. But current worries can quickly be forgotten if good news emerges.

There’s an expression common among investors, that “things are never as good or as bad as they seem.” Right now, of course, things look bad. Vladimir Putin’s actions are appalling, and it’s hard not to feel uneasy. But who knows? This crisis could end sooner rather than later, and with less loss of life than observers currently fear.

In the meantime, I think it’s important, when it comes to your finances, to keep your eye on the long term. Try hard to avoid being spooked by bad news. Just as the fate of any company’s share price never hinges on just one factor, the same is true of the overall market.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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Peter Blanchette
Peter Blanchette
9 months ago

All this talk of stock picking skills mask the real issue about index vs active. THE REAL ISSUE IS ABOUT FEES. Go to your handy dandy excel spreadsheet. Do this exercise. Mimic an index fund with say a .05% fee and compare to a hypothetical active fund earning identical returns and produce that return over say a 30 to 40 year period with different active fund scenarios where you take active funds with different fees of 1%, 1.5%, & 2% fees. Compare the total $ accumulated under the 3 scenarios. Then you can make your decision on what is best for you. Do you want to use a CFP who is going to assess an additional fee on top of the active funds he or she recommends. Is the advice from the CFP worth the differential in accumulation over 30-40 year time frame(annuities, LTC,Life Ins,Estate issues)? Bond investing is much different than stocks because the GREATEST BOND MARKET IN HISTORY is done for at least the near future. An active bond manager is going to find the cracks in the market to maximize what little the bond market offers at this period in our history.

Ormode
Ormode
9 months ago

To be fair to fund managers, they often have to bow to the naive investors who buy their funds. When stocks are soaring, new money pours in, but there are few good stocks to buy. When the market swoons, the money flows out the door, and the manager has to sell, even though he knows he should be buying.
That is why people who manager their own money, and don’t have to worry about this, can do better…..if they can successfully analyze corporate financials and business models.

Purple Rain
Purple Rain
9 months ago

Excellent post. I have an indexed portfolio (in my retirement accounts) and a dividend growth portfolio in my other accounts. Selling is not a problem since I buy and HOLD as in never sell) and expect to meet most of my expenses off the growing dividends. Case in point:

https://www.morningstar.com/articles/760208/revisiting-80-years-of-sloth

“Warren Buffett could have been describing passively managed Voya Corporate Leaders Trust’s (LEXCX) approach rather than his own when he said, “Lethargy bordering on sloth remains the cornerstone of our investment style.” Buffett has nothing on this fund, which celebrated its 80th birthday in 2015, when it comes to sloth. Nevertheless, it has beaten the S&P 500 over a number of decades despite maintaining a largely static portfolio. This makes the fund an anomaly among open-end offerings (even among index funds). But its uncommon strategy and success hold potential lessons for investors of all stripes.”

Last edited 9 months ago by Purple Rain

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