June 8, 2023

Why Picking Individual Stocks Doesn’t Work

$100 bills don’t lie around on the street very long.



A cartoon image featuring two speech bubbles. The first, in a black outline, reads 'How do I pick the right stocks?' The second, in an orange outline, responds 'If it were that easy, we would all be billionaires.' The image conveys the difficulty of choosing profitable stocks.

Most fund managers underperform their benchmark. Each day, the global financial markets process millions of trades worth hundreds of billions of dollars. These trades reflect the viewpoints of buyers and sellers who are investing their capital. By using these trades as inputs, the market can function as a powerful information-processing mechanism, aggregating vast amounts of dispersed information into prices and driving them toward fair value. Investors who attempt to outguess prices are pitting their knowledge against the collective wisdom of all market participants.

Graphic with a crowd of figures in dark blue silhouette and a single orange figure standing in front, with a speech bubble stating 'YOU ARE ALL WRONG!' Represents the challenge of going against market consensus.
Simple dialogue graphic with the question 'So, I shouldn’t pick individual stocks?' and the emphatic response 'NO!' in orange, highlighting the blog's stance against stock-picking in favor of a broader investment strategy.

Mutual fund industry performance offers one test of the market’s pricing power. If markets do not effectively incorporate information into stock prices, then opportunities may arise for professional managers to identify pricing “mistakes” and convert them into higher returns. In this scenario, we might expect to see many mutual funds outperforming benchmarks. But the evidence suggests otherwise.

A graphic with a speech bubble that asks 'Can I see the numbers?' and a single word 'ALWAYS' in orange, suggesting the importance of empirical evidence in financial decisions.
Bar chart titled 'Success Rate of Equity Funds Over Time' for 10, 15, and 20-year periods ending December 31, 2018. It shows a declining number of funds that survive and outperform over time with only 21%, 18%, and 23% of funds being winners at 10, 15, and 20 years, respectively, highlighting the difficulty of sustaining success in equity investment.

Investors may be surprised by how many mutual funds disappear over time. Less than half of the equity and fixed-income funds survived after 20 years. The evidence suggests that only a low percentage of funds in the original sample were “winners”—defined as those that both survived and outperformed benchmarks.

Image of a speech bubble with the question 'But, what about managers that have proven they can outperform?' followed by the word 'WELL...' in orange, expressing skepticism about the consistency of fund managers' performance over time.

Some fund managers might be better than others, but track records alone may not provide enough insight to identify management skill. Stock and bond returns contain a lot of noise, and impressive track records may result from good luck. The assumption that strong past performance will continue often proves faulty, leaving many investors disappointed.

A dialogue graphic questioning 'What if you could identify outperforming managers, how much better would returns be?' with the response 'A lot less than you might think.' indicating the minimal impact of choosing outperforming managers on investment returns.

The chart below shows return difference between fund managers and their benchmark.  The obvious takeaway is that most managers underperform their benchmark by 0.50% to 2.50%.  The surprising takeaway is that the best managers only beat their benchmark by ~0.50%.

Histogram titled 'The Probabilities & Payouts' showing distribution of 10-Year Annualized Excess Returns for Surviving Active Large-Blend Funds. The majority of funds cluster around zero, indicating that most do not significantly outperform or underperform the benchmark.
Text image saying 'So what you're telling me is...' which indicates a lead-in to a conclusion or summary, suggesting a realization or understanding about the discussed topic of investment strategy.

1. Only 20% of managers outperform their benchmark

2. Outperforming managers add around 0.50% of extra return

3. The fee difference between a passive vs. active fund in Canada is 1.29%

A speech bubble with the statement 'IT IS ILLOGICAL FOR INVESTORS TO PAY AN ADDITIONAL 1.29% IN FEES FOR A CHANCE TO MAKE AN EXTRA 0.50%!', criticizing the cost-efficiency of higher investment fees versus potential returns.

Despite the evidence, many investors continue searching for winning mutual funds / individual stocks and look to past performance as the main criterion for evaluating future potential.  This leads to inconsistent performance, high fees, and tax inefficiency.  

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Q: Is it hard to beat the stock market by picking individual stocks?

A: Yes, it is generally considered difficult to consistently beat the market by picking individual stocks. Here are a few reasons why:

Efficient Market Hypothesis: The efficient market hypothesis suggests that stock prices already reflect all available information, making it challenging to consistently identify undervalued or overvalued stocks. In an efficient market, it becomes difficult to gain a sustainable advantage and consistently outperform the overall market.

Information and Competition: Markets are highly competitive, with numerous professional investors and institutions analyzing stocks and seeking profitable opportunities. Access to information is widespread, and any new information that could impact stock prices is quickly reflected in the market. It is challenging for individual investors to have an informational edge over other market participants.

Behavioural Biases: Individual investors can be prone to behavioral biases that can lead to irrational decision-making. Emotions such as fear and greed can influence stock selection and timing, often resulting in suboptimal investment outcomes. Emotional biases can cloud judgment and make it difficult to consistently make objective and rational investment decisions.

Lack of Diversification: Picking individual stocks exposes investors to company-specific risks. Even if one stock performs well, a concentrated portfolio increases the potential for significant losses if that stock underperforms or faces financial difficulties. Diversification across different stocks and asset classes helps manage risk and reduces the impact of individual stock performance.

Time and Skill Requirements: Successful stock picking requires significant time and effort devoted to research, analysis, and monitoring. It necessitates a deep understanding of company financials, industry dynamics, and macroeconomic factors. The skill and expertise needed to consistently pick winning stocks are beyond the reach of many individual investors.

While there are instances where individual investors have achieved notable success in picking stocks, it is often difficult to replicate such outcomes consistently over the long term.

Many studies have shown that, on average, professional fund managers and individual investors who engage in active stock picking tend to underperform the broader market over extended periods.

For most investors, a more prudent approach is to focus on diversification, asset allocation, and adopting a long-term investment strategy. Passive investing through index funds or exchange-traded funds (ETFs) that provide broad market exposure is a popular alternative.

Source material and text taken from: Don’t Bother Trying to Pick Stocks