STOCK PICKING. What is it? And is it possible to win the investing game using this strategy?
Let’s be clear. Stock picking is a myth. It goes something like this: some individuals or management teams can consistently beat the market (net of their added costs) over a long period of time by selecting the best stocks available and by making frequent “advantageous” trades with other equity investors.
Stock picking is a strategy used primarily by mutual fund managers, but also by a growing number of individual investors. This strategy, like market timing, is one used in an attempt to beat the market’s return.
Before I debunk the myth, let’s first define the market.
In one sense, the entire stock market is “the market.” You would include all small companies, all of the largest companies, and all of the companies in the middle. You would include all lower priced stocks and the higher priced ones – these are the value companies and the growth companies, along the entire size continuum. You would include all of these categories of companies in every free country in the world that has an exchange where trades can be freely made and where private property rights can be adequately protected.
For most investors, using this broad definition is impractical, especially for Stock Pickers, because they are almost never interested in how companies in obscure places like Argentina or China are performing; stock picking “gurus” are not buying and selling companies there. So, the industry has broken the entire market down into smaller chunks. To make it easier to track we create an index for certain kinds of stocks. The S&P 500 is the most common index representing the 500 largest publicly traded companies in the United States. The Russell 2000 is the next most popular – it is an index tracking the results of the 2000 smallest companies in the United States. There are similar index tracking formulas for value companies and then for each sector internationally as well. When we say “beat the market” we mean that the manager’s fund performs better than the index that best represents their mix of stocks.
Here is where Wall Street gets sinister and where a conflict of interest arises.
First, remember that stock pickers don’t do what they tell you to do. You are told to “buy and hold” while they buy and sell, and they do it at a rate that averages nearly 100% of their holdings every year. In other words, active fund managers (this is what we call stock pickers) on average make as many trades each year as the number of stocks they hold. Remember too that they get paid to make these trades – every time. The commission they make is derived from the “bid-ask spread”. This is the difference between the buy price and sell price of a stock, and it compensates the market maker who facilitates these trades. The system is a good one, but the abuse is rampant.
So, the stock picker makes a ton of money every year buying and selling stock with your money whether or not you make money. How do they convince investors to keep doing this?
It would be easy for them to do it if they actually beat the market. They would simply show you how they beat the market and then you would give them more of your money because you would see the cost benefit of doing that. And, sometimes some people legitimately do beat the market for a time. When this happens, like with Peter Lynch in the 80s, the company promotes their winner and a ton of money comes in. More money, more trades, more revenue.
But what do managers do when they don’t beat the market?
They make it look like they did. They can do this a number of ways, from “cherry picking” time periods when performance was better, to changing a few stocks in the portfolio so that they can shift to an index against which their returns compared better. The fact is—and this is supported by any study you’ll find on the topic—that winning fund managers do not repeat their performance.
Let me say that again.
Stock pickers, even those who have a good five or ten-year run, do not repeat their performance.