The Stock Picker’s Quest for Alpha - MoneySense

The Stock Picker’s Quest for Alpha

Among academics, the active-versus-passive debate often centres on mutual funds. But among DIY investors—who readily concede that mutual funds with high fees are unlikely to outperform an index strategy—the discussion usually focuses on stock picking. Many people who shun mutual funds believe that building their own portfolios of individual stocks offers a high likelihood of […]

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Among academics, the active-versus-passive debate often centres on mutual funds. But among DIY investors—who readily concede that mutual funds with high fees are unlikely to outperform an index strategy—the discussion usually focuses on stock picking. Many people who shun mutual funds believe that building their own portfolios of individual stocks offers a high likelihood of market-beating returns.

At a recent symposium in Toronto hosted by Dimensional Fund Advisors, I listened to financial author Larry Swedroe discuss this idea and others in his book The Quest for Alpha. Swedroe also spoke the night before to a group in Ottawa that included several bloggers. Some were put off by Swedroe’s assertion that investors should not be picking individual stocks.

It’s impossible to make sweeping conclusions about the performance of retail investors who pick stocks, because the data are hard to get, at least compared with what’s available in mutual fund databases. Any researcher can look up the performance of funds, but how can we possibly know how successful individuals are?

Here’s what we know

In fact, there have been a number of studies by researchers who had access to account data from brokerage firms, and some of these are discussed in The Quest for Alpha. The most influential work has been done by Brad Barber and Terrance Odean in California, who have been at it since the 1990s. You can read Swedroe’s book for a summary of the research, or track down the individual papers, but the findings are about what you would expect. Investors routinely underperform risk-adjusted benchmarks, and the less they trade the better they do. Perhaps this quote from Odean sums up the research best: “The point seems to be that individual investors for the most part shouldn’t be trying to pick stocks. They did worse than if they had been throwing darts.”

Swedroe also raises another important issue: most individual investors, whatever strategy they happen to use, don’t know how to measure their performance. There is plenty of anecdotal evidence for this—just read my previous post about yield on cost, or go to any investment show and ask people if they’re beating the market: all of them will say yes. But anecdotes are not evidence, so Swedroe again goes to the research.

In a 2007 study, Markus Glaser and Martin Weber got access to online brokerage accounts and then asked the investors a series of questions about their own performance. Swedroe summarizes the findings both in the book and on his blog, and they are alarming. Echoing Barber and Odean’s work, the study found rampant overconfidence and consistent underperformance among investors who dramatically overestimated their returns. Four out of every five investors who had negative returns were unaware they had even lost money.

Tarring with the same brush

The research is clear that the overall performance of individual investors is worse than that of high-priced mutual funds. You might conclude from these studies that stock picking is an entirely futile exercise. But I would argue that’s too ham-fisted. What the studies show is that investors who trade too frequently get clobbered. There is no doubt that experienced, educated investors will perform much better than the average person in these studies—indeed, Glaser and Weber state this explicitly in their paper.

In my last post, I argued that disciplined, patient and courageous investors (to use Tom Bradley’s words) can do just fine if they stick to low-cost, well-run active mutual funds. Surely the same is true for stock pickers with those same traits. If they diversify properly, keep turnover extremely low, stay invested during the rough times, and control their emotions, they’re unlikely to go too far wrong—even if they don’t end up beating the market.

I’ve been surprised to hear how many investors use some combination of indexing and stock picking, and who seem to be making it work. If you find a purely passive strategy impossible because you can’t make peace with the idea of buying the whole market, then a side order of stock picking probably makes sense. If the comfort of holding individual stocks is what makes you adhere to your investment plan, then there is enormous value in that.

I’d still like stock pickers to read Swedroe’s book, so I’ll send a free copy to the reader who leaves the most interesting comment below. Rather than simply pulling a name from a hat, this is one contest I’m going to actively manage.

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