Why Stock Picking Is A Losing Game
Recently I had a friend ask an innocent and well-meaning question on Facebook. “What stocks should I buy?” he wrote, and the comments came flowing in. Each one was as cringeworthy as the next.
“Companies that use graphene in computers” one person wrote.
“Amazon, Facebook, and Google” chimed another.
“Companies with values you agree with” mentioned a third.
Among all the chaos in the comments section, there was a voice of reason. “An index fund with low fees,” she said. I wrote my obligatory comment as a financial advisor, I liked the only other sensible comment, and I moved on. But then I realized that I’ve never explicitly talked about stock picking vs index investing on this blog. It’s among the most fundamental rules of managing your own finances, and I’ve failed to dive into it for my audience here.
So here goes…why stock picking is a losing game
First off, let’s set the ground rules here. There are basically 3 main ways to invest your money.
- Actively pick stocks
- Invest in broad-based asset classes to diversify risk (this is a fancier way of saying get a collection of index funds)
- Put all money under your mattress/pillow/savings account
Spoiler alert – the correct answer is #2. But why? #3 is a bad idea because long run savings account rates are under 1% per year, which means that for every $1000 you invest, it’ll take about 72 years for that money to become $2000. Considering inflation will eat away those returns faster than they will grow, you’ll lose more money than you make. Still don’t believe me? How many wealthy people do you know that keep all their money in a savings account?
Now that we’ve gotten that out of the way, let’s talk through why #1 isn’t a good idea.
First off, nobody denies that you can make money actively picking stocks. You can. But that’s not the question. The question is whether you can make more money than if you choose the second option. #2 is what’s commonly referred to as “passive management” – which as the name suggests, means that you don’t have to do much to it. You buy the index funds and let them sit forever and ever (with some tweaking here and there called rebalancing…but that’s not important to this discussion).
Option #1 takes A LOT of work. You have to know about the fundamental value of the company, anticipate their new business lines better than they can, know how to read financial statements, and more. You have to evaluate every single company this way. Then choose the specific ones you want. On top of that you have to have a lot of money in the market to properly diversify since buying one company is the most stupid and risky way to invest. That’s why this strategy is called “active management.” It’s hard.
So since it’s so hard to do correctly and it takes so much time and you have to be so smart to make it work, you’d think that the people who can do it right would make more money than the suckers who choose #2? Wrong. For those of you who aren’t going to click that link, let me recap the headline for you here. 99% of actively managed US equity funds underperform.
What does it mean to underperform? Ok so there are these big indexes you’re probably familiar with like the S&P 500. That one is just a list of the top 500 largest companies in the US. No fancy math or algorithms to pick winners and losers. You just buy a little bit of each company and hold it. Not very exciting…but only 1% of those actively managed funds could beat it over a 10 year period. These are people with PhDs in statistics and finance using the fanciest algorithms and computer trading models and human insight and they couldn’t beat the simplest investing strategy in the world.
I can beat the market
At this point you might be saying “but I’m smart – I can be in the top 1% that beat the market.” And to that I say, no you can’t. If you’ve written on Facebook asking a bunch of your friends which stocks to buy or you have a full time job that would prevent you from pouring over financial documents for hundreds of hours each week, then no, you don’t have what it takes to beat the market.
Let’s take the world’s most famous investor as an example. Warren Buffett (who has a better track record of investing than anyone in history) even thinks it’s silly to try to beat the market. The only reason he can do it is because he has so much money that he can buy controlling stakes in each company he wants. When you buy 40% of Coca-Cola, you can decide how it’s managed. So really Warren Buffett might not be such an incredible investor as much as he’s an incredible manager and executive. You might be able to buy a few shares in any given company – but not nearly enough to take control and manage those companies until they give you returns that beat the market.
And remember, you don’t only have to beat the market. You also have to be able to beat Warren Buffett. Because when he works wonders on the companies he buys, that stock value increase is logged as a small part of an index fund somewhere, making the market that much more difficult to beat.
If you can’t beat ‘em, join ‘em
So since every frat boy, PhD, institutional investor, billionaire, and hedge fund manager thinks they can beat the market, the result is that they make the market what it is. All of their fighting and one-upmanship actually serves a purpose though. You’re the one who reaps the gains. They buy and sell and buy and sell, and all the while you get rich using the time tested set it and forget it strategy. Sit back, relax, and let the good times roll.
Nathan is the Chief Financial Advisor at Monte Largo Financial
Quick note – this post should not be construed as advice that you should only hold the S&P 500. A well-diversified portfolio includes a variety of different asset classes that are appropriate for the person’s age, risk tolerance and goals. The S&P 500 was only given here as an example of an index, not as a singular investment strategy.