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IN THE INVESTMENT world, May 1st is a notable day. It was on May 1, 1975 that the Securities and Exchange Commission deregulated the brokerage industry. For the 183 years prior to that, trading commissions on the New York Stock Exchange had been fixed at uniformly high rates. But when deregulation arrived, competition got going. That’s when discount brokers like Charles Schwab got rolling, and over time, May Day, as it’s now referred to, has delivered enormous savings to consumers.
More than 50 years later, though, Wall Street still operates in ways that are often at odds with consumer interests. As an individual investor, what are the obstacles to be aware of?
At the top of the list is Wall Street’s fixation with individual stocks. For almost 100 years, the data has been clear that stock-picking is counterproductive. Probably the first to uncover this was a fellow named Alfred Cowles. Cowles came from a wealthy family and wondered whether the investment advice his family had been receiving was worthwhile. He set about answering that question and in 1933, published a paper titled “Can Stock Market Forecasters Forecast?” Cowles’s conclusion: They can’t.
More recently, research by finance professors Brad Barber and Terrance Odean came to a similar conclusion. The title of their most well known paper is self-explanatory: “Trading Is Hazardous to Your Wealth.”
Along the same lines, Standard & Poor’s regularly examines actively-managed mutual funds to see how many are able to outperform the overall market. The most recent finding: Over the past 10 years, fewer than 15% of funds benchmarked to the S&P 500 managed to beat the index.
Research by Jeff Ptak at Morningstar has found that the more active a fund is, the worse it performs. So-called tactical funds, which shift among different asset classes in response to economic forecasts have, in Ptak’s words, “incinerated” shareholder dollars.
This data is fairly well known. The problem, though, is that trading activity generates revenue for the brokerage industry, so it has an interest in keeping investors engaged with the market. That’s why brokerage analysts are on TV every day, offering their forecasts for individual stocks, for the overall market and for the broader economy. To be sure, this makes for interesting television. The problem, though, is that it’s been shown to carry almost no value. According to research by Joachim Klement, the accuracy of Wall Street prognosticators is approximately zero.
Why are they so poor at forecasting? For starters, there’s the simple fact that no one has a crystal ball. No one can know what a company—or its competitors—will do a month or a year from now, and how that will translate into stock price gains or losses.
Sociologist Ezra Zuckerman Sivan uncovered a more subtle explanation. In research published after the technology selloff in 2000, Sivan found that Wall Street analysts are constrained by two obstacles. The first is that they’re dependent on access to companies’ management teams to help in their research. For that reason, it’s in their interest to maintain positive relationships with the companies that they follow.
Investment banks that take a positive view on a company may also be rewarded with profitable mergers or acquisitions work when the need arises. Those factors bias stock recommendations overwhelmingly in the direction of “buy” ratings.
Another reason analysts tend to avoid negative comments about the companies they cover: Sivan found that there is a community effect that tends to form among the analysts assigned to a given company, and thus an incentive develops to not “rock the boat” in saying anything too critical. People generally want to get along, and that results in a sort of self-censorship.
This research is well understood, and yet Wall Street continues to generate forecasts day after day, year after year. Why? There are two explanations, I believe. The first is that it’s entertaining. I’ll be the first to acknowledge that index funds aren’t terribly interesting to talk about. It’s far more interesting to talk about smartphones or AI and the companies behind them. That makes Wall Street analysts invaluable to the media, who need to fill airtime.
And as long as they’re granted that airtime, forecasters are of great value to the brokerage industry. Since trading activity is profitable for Wall Street, it’s in brokers’ interest to generate continued interest in stocks. That brings in commission dollars for brokers. And even though commissions have shrunk in recent years, brokers benefit in other ways from active trading, including the “bid-ask spread” on each trade. That’s the difference between what buyers pay and what sellers receive, and though these spreads are tiny, they add up for the brokers who collect them.
For good reason, then, Wall Street continues to promote stock-picking. At the same time, the investment industry is always busy developing new funds. In the first half of last year, for example, fund companies rolled out more than 640 new funds. Among them: funds that hold single stocks with varying degrees of leverage and other seemingly unnecessary new formulations. The result: There are now many more funds than there are stocks trading on U.S. exchanges.
Many of these new funds follow ever more esoteric strategies. They’re often opaque. And almost invariably, they carry higher fees. In a 2011 study titled “The Dark Side of Financial Innovation,” finance professor Brian Henderson and a colleague looked at one popular category of fund known as a structured product. Their conclusion: These funds were overpriced to the point that their expected return was actually a bit below zero. How were they able to market such an inferior product? Henderson’s hypothesis was that the fund companies designed them to be intentionally as complex as possible in order to exploit individual investors.
The bottom line: To a great degree, Wall Street is upside down. But as an individual investor, you don’t have to be. My rule of thumb: In building a portfolio, investors should do more or less the opposite of what Wall Street recommends. That, I believe, is a reliable formula for success.
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 X @AdamMGrossman and check out his earlier articles.
Yes, the stock market consists of individual stocks – each company is a separate legal entity that has its own capital, product, and sales. This is the real world
As the stock market moves away from the the real world, stocks become trading tokens detached from the actual companies doing real business. To my mind, this is not the way it should be.
I treasure your weekly columns. They are always truthful, useful and on point Thank you.
Spot on Adam. You are preaching to the choir on this forum. Thanks.
Great stuff, Adam. You truly pulled up the curtain!
Excellent article, keep them coming. It took me about 35 years or more to learn this, but now at 80 I am very happy with 75% S&P, 10% individual stocks, basically Mag 7, and 15% cash, no bonds. This is working well for me. And yes investing for about 60 years, when I had mostly individual stocks, my average thankfully was about the same as the S&P, almost no one picks all winners! Exception, a very few and Warren Buffett.
I have a friend who invests in individual stocks and watches financial news all day long. It’s his entertainment. He’s showing early signs of dementia and I’m sure the family has no way to interpret what he has been doing or if it even makes any sense. I’m not sure how you unwind a situation like this.
For our investments and my sisters, I’ve tried to set everything up in “drop dead” mode. Meaning I don’t have to be here for the next 10 or 20 years for the investments to work out. I guess that’s risk management of a sort.
It’s an important reminder that even for index investors, economic forecasters can be extremely dangerous.
I can’t imagine how much wealth is destroyed for those that continually adjust their asset allocation based on these forecasts.
Thanks Adam for starting my weekend off with another thought provoking article. While I generally agree with your conclusions on the financial benefits of index funds, I would like to offer another perspective on the entertainment value of stock picking. For many years my Father In Law ran his own mini large cap dividend fund in his brokerage account. In retirement especially, he would sit for hours watching the ticker on CNBC and keep track of his ~20 holdings as well as a short list of stocks he was watching. He did not reinvest dividends and instead would let them accumulate until he could purchase another stock. He kept a handwritten list of his holdings and daily closing prices until the day he passed away at 90. After he passed, my mother in law took up the practice of writing down the daily closing prices until she passed this year at 97. It was THE form of entertainment for them for over 20 years. When I became POA for my in laws, I started tracking the returns of their holdings vs. the S&P 500. Over the years I can confirm that they did pretty well. Now that they are gone, as executor, I am responsible for distributing the portfolio amongst the 4 children. The result is that they each are getting a portfolio that includes shares of Apple, Microsoft, Merck, Bristol Myers, Citibank, JPMorgan, just to name a few. They are also getting a piece of their father’s legacy that holds sentimental value as well. Just yesterday I had the pleasure of telling one of the beneficiaries about the portfolio she would be inheriting. It sparked a memory for her about how he would sit and watch the ticker for one of his holdings to pass by. It was, as they say, priceless.
I was able to retire 26 years ago at age 51, mostly because of my portfolio of individual stocks. Was I a great stock picker? No, I was lucky. I did do a lot of research on the stocks, looking for ones I thought would do well over 10-15 years. All of my individual stock investments were less than $5,000. Most were mediocre investments; a few were outright awful. However, 3 of the stocks performed spectacularly over the 15-20 years that I owned them. All 3 were in mundane industries. I was an engineer but never invested in tech stocks because I knew that few of them would survive in the long term.
I ended up with a large portion of my net worth in the 3 stocks in a period when taxes on long-term capital gains were much higher than they are today. I took me several years to diversify my holdings.
Now, I only own broad-based index funds. I would not recommend that anyone have a significant portion of their portfolio in individual stocks.
Great article, Adam. No holds barred. It’s a shame that something so crucial to a person’s financial well-being can get so caught up in interplay between sellers and media. Giving ourselves over to the latest hyped-up home or leisure gadget might give us empty value without causing us much harm. But getting seduced by the Wall Street pitch can be devastating.
Great article today Adam, thank you. CNBC has a great deal of time to fill every day. For me, it’s nothing but noise from talking heads. I only tune in now if there is something really, really big going on. There is no real signal there, even if I had a great antenna. I’ve read all of Nassim Taleb’s books backwards and forwards and he emphasizes, regarding people and their opinions, that he only listens to the opinions of people who have skin in the game. I find that to be pretty good advice.
Burton G. Malkiel still looks pretty good, 60 years after “A Random Walk Down Wall Street.” Basically he concludes (at the end of a book that’s surprisingly entertaining to read) that you can’t beat the market by stock-picking (except by taking on more risk, which means… taking on more risk!). Long before Bogleheads were a thing, this basic truth was already known — but lost in the noise.
Good article, Adam. I agree wholeheartedly but would add one thing. We still need for a lot of people to buy individual stocks for purposes of finding the right price of the stock. Funds/ETFs rely on having the stocks they are holding priced correctly if there is to be true valkue there.
I agree with you entirely. I do feel, however, that the hype for some stocks is distorting their value in the indexes.
I seem to get daily emails and phone notifications recommending individual stocks. Personally, I’ve always followed one simple rule: ignore the noise. It’s certainly served me well over the years.
Great article. I follow a lot of the Wall Street strategists’ social media posts and get their emails, etc. Super smart people and I feel like I learn a lot about the market environment as I read. Then they conclude with, “We expect a wide dispersion of returns, putting a premium on stock selection.” And you just know they HAD to say that.