- Maximizing Your Investments: Top Assets for Small Budgets - June 20, 2023
- Investing Made Easy: A Beginner’s Guide to Index Funds - March 30, 2023
- Do Index Funds Have Fees? [Don’t Overpay] - March 21, 2023
The term “stock picking” refers to picking and investing in specific stocks that you think will outperform the market average. Stock picking is risky and is not for everyone – people dedicate their whole careers to picking stocks but still have a difficult time.
In this article, I will break down the details and give you some statistical insight about stock picking.
Actively Managed Mutual Funds That Stock Pick Underperform The Market
Have you ever tried to invest in the stock market? Ever tried to read a balance sheet? Or learn fundamental analysis? Learning about how to analyze stocks is tough work. That is why many people rely on the expertise of fund managers to do the hard work.
Fund managers of actively managed mutual funds stock pick and choose the stocks their fund will invest in – the hard work is done by the fund manager.
However, the majority of actively managed funds underperform the market. In Jack Bogle’s book The Little Book of Common Sense Investing, he mentions a study that was done on such mutual funds.
The study was conducted on 355 funds from 1970 to 2005, and measured to see which funds could outperform the S&P 500. These were the results:
- 223 funds went out of business (80%)
- 48 funds performed the same as the S&P 500 (13%)
- 24 funds outperformed the S&P 500 (7%)
Statistically, you only had a 6% chance of outperforming the S&P 500. This is a very slim chance and would need a lot of luck to play in your favor.
If fund managers that dedicate their whole career to stock picking have a hard time outperforming the market, it’s safe to assume that average individuals like you and me have it more difficult.
Stocks Revert Back To Their Mean
Markets are self-efficient. Although some stocks/funds may outperform the broader market, they always revert back to the cost of their intrinsic value. In other words, stocks and funds that are overpriced cannot sustain their performance; their price will always go back down to their actual value.
Let’s say you were lucky and managed to pick one of the funds in the 6% that outperformed the S&P 500. There is still no guarantee that the fund will continue to outperform in the future.
We will take a look at another one of Bogle’s studies. For this study, he took the top 20 performing funds of each year from 1982 to 1992, and from 1995 to 2005.
The results showed that those top 20 could only outperform 58% of the other funds.
As you can see, funds that outperformed were not able to sustain their performance. During subsequent years, those funds had below average returns.
Businesses Come And Go – So Do Stocks
When you buy a stock, you are actually buying a portion of ownership of that business. For example, if I buy one Microsoft stock, I technically own a part of Microsoft – that is, a miniscule portion.
Trends and businesses both have one thing in common: they come and go.
Let’s time travel and look at the top 10 companies of the S&P 500 in 2000.
- General Motors
- Wal-Mart Stores
- Exxon Mobil
- Ford Motor
- General Electric
- Int. Business Machines
- Citigroup
- AT&T
- Altria Group
- Boeing
Source: CNN Money
Let’s fast forward to today and take a look at the top 10 companies.
- Apple
- Microsoft
- Amazon
- Tesla
- Alphabet Class A
- Alphabet Class C
- NVIDIA
- Berkshire Hathaway Class B
- Meta
- UnitedHealth Group
Only 20 years ago, yet the difference in composition is evident. This is because as technology advances, trends and businesses change.
If you were invested in any of the top stocks in the 2000s, your portfolio might have not done so well. By simply investing in an S&P 500 index fund, you wouldn’t have to stock pick, or worry about which businesses will continue to prosper and which will go under.
Didn’t Warren Buffet Stock Pick?
A lot of you may be asking yourselves, “but Warren Buffet was able to succeed at stock picking?” And yes, that is true. However, the decision he made that added a lot to his net worth was also a bold and risky one.
Back in the 1950s, early on in Buffet’s career, he decided to invest half of his net worth into Geico, the insurance company that everyone knows about.
Buffet went down to Geico’s office one day and learned about the company’s unique advantages. Benjamin Graham, one of Buffet’s teachers had warned Buffet to wait for the stock market to pull back before investing. But Buffet went ahead and bought 350 shares at around $29 per share. By the end of the year, Geico’s stock closed at $37.50.
Buffet made a risky decision by putting half of his net worth into one stock. No one would’ve known if Geico’s stock would have soared or plummeted. As a matter of fact, the company almost went bankrupt in the 1970s.
Furthermore, the strategy that Buffet uses involves buying high-quality companies with a cheap stock price. It is important to note that it’s the overall strategy that works, not his stock-picking skills.
You can follow Buffet’s strategy, but it’s easier for anyone to access this strategy by buying mutual funds or ETFs, as the cost of investing in one of these is next to nothing.
For example, Fidelity offers an S&P 500 index fund with no expense ratio.
Conclusion
Stock picking is a difficult task and is not for everyone. It takes a lot of training on fundamental analysis, and also requires some luck as well. You could invest in one of the best stocks and they can still go bankrupt.
The best way to avoid such a headache is to invest in a low-cost index fund that tracks the S&P 500. Companies that go bankrupt will automatically be removed from the S&P 500, and it requires no work on your behalf! Are you ready to invest in an index fund? Click here to read our article on the best index funds.
Have you ever tried stock picking? Which stock did you pick? I would love to hear your stories in the comments!