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Step 3 - Stock Pickers

index funds

 
Step 3 - Introduction

The most common form of active management is stock picking. On average, stock pickers will always lose by the amount of their costs and expenses. Some will do better and some will do worse than an appropriate or blended benchmark of risk factors. Since the average return of the market is the average return of all investors, the average investor gets the average return. Although you may think that you can choose or be the investor who beats the others, the probability of a money manager outperforming other managers each year is equal to getting heads on the toss of a coin: 50/50. This is because the markets are random, just like the coin toss. The chances of a manager beating a market over the long term (more than 10 years) were 1 in 36 in one study, and 1 in 39 in another 30-year study! You would be better off betting on one number on the roulette table in Vegas, where odds are 1 in 38. So far, we have collected over 200 articles measuring the performance of active managers, starting with Alfred Cowles in 1933, and the results are not good for active management.

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Step 3 - Overview

Stock pickers are exactly what their name implies - active investors who pick stocks or even mutual funds based on perceived mismatches between the current market prices and their supposed true values. This is a major problem. In this random and efficient market, there are no mismatches between the current market prices and their true value. Stock pickers are listening to their feelings and instincts when deciding what stock to pick. A study in this Step reveals that the chances of the active manager beating the appropriate index are one in thirty-six, the same long shot as throwing snake eyes at the craps table! Less than three percent of managers even beat their proper benchmark. Unlike methodical index investors, active investors who try to stock pick are little more than gamblers who rely on raw emotion and their imagined ability to predict tomorrow's news. As Nobel Laureate Bill Sharpe asks, "why pay people to gamble with your money?" When investors pay high loads, commissions or fees to stock pickers, it may be more appropriate to refer to them as pocket pickers.

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Step 3 - Quotes
Nobel Laureate William F. Sharpe" it turns out for all practical purposes there is no such thing as stock picking skill. It's human nature to find patterns where there are none and to find skill where luck is a more likely explanation (particularly if you're the lucky [mutual fund] manager)." Mutual fund manager performance does not persist and the return of stock picking is zero." We are looking at the proverbial bunch of chimpanzees throwing darts at the stock page. Their "success" or "failure" is a purely random affair "

William Bernstein, The Intelligent Asset Allocator
Nobel Laureate William F. Sharpe" If there's 10,000 people looking at the stocks and trying to pick winners, one in 10,000 is going to score, by chance alone, a great coup, and that's all that's going on. It's a game, it's a chance operation, and people think they are doing something purposeful... but they're really not. "

Merton Miller, Nobel Laureate and Professor of Economics, Univ. of Chicago, Transcript of the PBS Nova Special,"The Trillion Dollar Bet"
" Empirical evidence provides no support for the claim that active management of small-cap portfolios is more fruitful than it is for large-cap portfolios. "

Richard M. Ennis, The Small-Cap-Alpha Myth


" The economists arrived at a devastating conclusion: it seemed just as plausible to attribute the success of top traders to sheer luck, rather than skill. "

Transcript of the PBS Nova Special, "The Trillion Dollar Bet"
Peter Lynch" After taking risk into account, do more managers than you'd see by chance outperform with persistence? Virtually every economist who studied this question answers with a resounding "no." Mike Jensen in the Sixties and Mark Carhart in the Nineties both conducted exhaustive studies of professional investors. They each conclude that in general a manager's fee, and not his skill, plays the biggest role in performance." [the higher the fee, the lower the performance "

Eugene Fama, Jr.

" I have been a stockbroker for 5 years and have made people money, but I always lose it in the end.

I have taken huge risks with my clients. I have lost millions, but I am tired of looking for new clients. "

Anonymous Stock Broker Sept., 2001
Peter Lynch" Very little evidence [was found] that any individual [mutual] fund was able to do significantly better than that which we expected from mere random chance. "

Michael Jensen, "The Performance of [115 US Equity] Mutual Funds in the Period 1945-1964", Journal of Finance, May 1968
Nobel Laureate William F. Sharpe" It's like giving up a belief in Santa Claus. Even though you know Santa Claus doesn't exist, you kind of cling to that belief. I'm not saying that this is a scam. They generally believe they can do it. The evidence is, however, that they can't. "

Professor Burton Malkiel: - ABC News Program: 20/20, November, 1992
Peter Lynch" The only way to "beat an index" is to invest in something other than the index. Why would you, when the only source of long-term risk and return data IS the index? Since you can't beat the index, be the index."

Mark Hebner, Founder, Index Funds Advisors, Inc.
" The implication [of the Efficient Market Hypothesis] for the investor is that it is almost impossible to "beat the market. "

12th Grade Economics Text Book, Economics, (even our kids are learning this)
" Investment managers sell for the price of a Picasso [what] routinely turns out to be paint-by-number sofa art. "

Patricia C. Dunn, CEO, Barclays Global Advisors (World's largest money management firm, approx $1 trillion of assets under management, approx 80% indexed)
  

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Step 3 - Definitions

Stock Pickers

Stock pickers are active investors who bet they can beat a market by picking stocks they believe will outperform an index. To be precise, the only proper comparison to their result is the portfolio they choose. All other portfolios will end up with different risk and return characteristics. Generally, they are taking more risk than the index, because they are concentrating their bets on fewer stocks than those in the index. When they allocate their portfolio differently than the index, they are guaranteed to obtain a different return and risk level. Sometimes it is more and sometimes it is less, but we can always assume it will be different when looking at both risk and return. Since it takes at least 20 years of risk and return data to confirm skill over luck, stock pickers are faced with a virtually impossible task in assuring continued success against the appropriate market index. However, indexes are a source of 20-year risk and return data, and consequently are the only logical choice for establishing efficient portfolios of various levels of expected risks and returns

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