June 7, 2024

There’s No Skill in Stock Picking

A recent WSJ article, “Taking a Random Path to Stock Riches”, touched on a number of key Fifth Set PWM investment principles around stock picking. 

The article draws its content from a competition that paired stocks picks produced by a series of random dart throws against those generated by a group of fund managers who presented their best ideas.  The random dart stock picks outperformed the fund manager best ideas by 48%.

A few key highlights:

“The biggest takeaway from our (WSJ) picks is that while there were a few other winners, a single stock, insurer Root Inc., was responsible for all our net gains”

The article goes on to mention research done by Hendrick Bessembinder who found that the vast majority of individual stocks underperform the overall market.  Historical broad market returns are driven primarily by a very small number of extraordinary outperformers.  This drives an important Fifth Set principle which is that if you want to capture market returns you either need to find the needle in the haystack or buy the haystack.  We choose the latter strategy.

“Dart throws, if done right, can beat the market in the long run, according to a study by Towers Watson and Research Associates”

The idea here is that there are many more small company stocks in the market than large company stocks.  As a result, a random throw of darts is likely to result in a portfolio with a higher proportion of small company stocks than the overall market. This “tilting” should result in a portfolio with a higher expected return than the overall market based on research that suggests small company stocks have a higher expected return than large company stocks.  For Fifth Set PWM,   rather than rely on darts, we purposely design portfolios with small company stock tilts.

“S&P Dow Jones Indices shows outperforming mutual funds in one period have very poor odds of following up.  In 2020, 43% of U.S. stock mutual funds beat their index.  Of that group, 2.5% kept it going for the next two years.”

Stock picking outperformance does not persist.  Even filtering by only including past winners, over time, fewer and fewer fund managers beat their benchmark.  The good news for investors is that “benchmarks” are investable through index and index-like funds.  As a result, investors can adopt an investment strategy that has been shown to outperform the vast majority of active stock picking mutual funds.  

These are examples of some of the core principles Fifth Set uses to build client portfolios.  Using evidence from academic research as the foundation for our portfolios helps clients stay in their seats when the market goes through its inevitable and unpredictable volatile periods.