In the spring of 2000, University of California professor Terry Odean published a research paper on the topic of investor behavior. The results weren’t pretty. On average, by Odean’s reckoning, individual investors lagged the overall market by nearly four percentage points per year. The culprit: the costs involved in trading individual stocks.
It’s not just individuals who struggle with stock-picking; professional money managers, on average, also trail behind the overall market. Over the past five years, in fact, Standard & Poor’s calculates that just 16 percent of mutual fund managers who attempted to beat the S&P 500 index actually succeeded. In other words, you would have had better luck — much better luck — flipping a coin. It is research like this that, in my view, provides such strong support for index funds — that is, funds that simply buy and hold large baskets of stocks instead of attempting to pick and choose and trading in and out.
It is perhaps understandable that casual investors have a hard time picking stocks. But, why is it that professional investors also have such trouble? Why is stock-picking such an uphill battle? This week the stock of Facebook provided a perfect case study to help answer this question.
By way of background, Facebook’s stock has had a rough week. The drama started last Saturday, when the New York Times published a damaging story about the company. In short, the Times revealed that well-connected political consultants had improperly acquired from Facebook personal data on more than 50 million Americans. Worse yet, they had been using this data to influence our elections, including the 2016 presidential election. And, there was evidence that the consultants still had this data, despite pledging years ago that they had deleted it. The fallout from this story has been extensive: Congress has demanded an investigation, investors have filed class action lawsuits and Facebook’s Chief Information Security Officer abruptly resigned.
In the wake of all this, the company’s stock has dropped more than 10 percent this week. That’s not surprising, but how exactly does this explain why stock-picking is such a losing proposition, even for professional investors? The answer is that, despite all of Wall Street’s resources, none of the three major branches of investment analysis could have predicted that this would would happen. To see why, let’s look at how each type of analyst viewed Facebook prior to this week:
1. Quantitative analysts focus only on a company’s financial metrics. They would have given Facebook high marks: Last year, for example, the company’s revenue increased nearly 50 percent, and profits grew even faster. It’s hard to find a company of any size delivering numbers like that, let alone one that has already achieved $27 billion in annual sales.
2. Fundamental analysts take a holistic view of companies, considering both quantitative and non-quantitative factors. They too would have given the company high marks. Facebook’s user base now stands at 1.4 billion people — about half of all Internet users worldwide — and nearly two-thirds of them log in every day. This has allowed the company to both sell more ads and to raise prices, something that, for most companies, requires a trade-off.
3. Technical analysts examine the shapes and patterns of stock charts to predict where they think a stock is going. What would they have found? Over the past five years, Facebook’s stock had been been moving up in virtually a straight line. So, they too would have predicted good things for the stock.
In other words, despite Wall Street employing a large and diverse army of analysts, none of them predicted this week’s 10 percent price drop. It’s not their fault; no one could have. No one — save for a few journalists — knew what was coming. And that’s precisely the problem with stock-picking. No matter how much time and energy one devotes to analyzing a stock, there’s just no way to predict these sorts of random, and very frequently occurring, events.
Does this mean that no one could possibly succeed at picking stocks? No, there are indeed stock-pickers out there with exceptional ability. But it is also exceptionally difficult to find them because they are such a minority. While stock-pickers may be hard-working and well-meaning, the reality is that the world is an unpredictable place, and that makes it an awfully difficult environment for them to succeed. For that reason, as tempting as it may be to place a wager on one company or another, I think the best path to wealth is to stick with a set of simple, broad-market index funds in an allocation that fits your stage in life.
To be sure, index funds aren’t perfect either. In fact, they buy as many, or more, poorly performing stocks as human stock-pickers. But, because they buy a small slice of every stock, and hold them through thick and thin, the impact is muted when any single one falls out of bed.