Last week, I discussed the perils of market timing. This week, I’ll address its close cousin: stock-picking.
These days, many people accept that stock-picking isn’t a great idea. Evidence shows that both professional and individual investors fare poorly, on average, when they choose individual stocks. But why exactly is that? How is it that indexes—which are simply lists of stocks—are able to so frequently outpace the results of experienced and motivated professional portfolio managers?
There’s more than one answer to this question. But recent data has helped narrow in on one key explanation. In a 2021 study of professional portfolio managers, researchers found that fund managers are actually pretty successful at picking stocks. On average, in fact, they outperform with the stocks that they buy. The problem lies on the other side of the equation. When it comes to deciding when to sell, that’s when portfolio managers fare poorly. And that, on average, is what causes actively-managed funds to underperform. Fund managers’ poor selling decisions more than offset their good buying decisions.
This study explored possible explanations for this phenomenon. Among them: Fund managers get scared when bad news impacts stocks in their portfolios. Every company, almost without exception, will go through difficult periods that weigh on its share price. In many, if not most, cases, companies emerge from these periods, and their share prices recover. The stocks may even outperform as the dark cloud passes. But in the middle of a crisis, when all the news is bad, it can be hard to see the light at the end of the tunnel. And that’s when portfolio managers tend to react poorly.
Consider this year’s most prominent example: Facebook parent Meta Platforms has seen its stock drop by nearly 40%, wiping out almost $400 billion of market value. What’s the problem: Apple recently implemented a set of privacy controls that limits Facebook’s ability to target advertising on iPhones. And Google has announced that it plans to follow suit with its Android platform. The impact has been noticeable. In its most recent quarter, Meta revenue and profits rose, but at a dampened rate. Compounding matters, Facebook also reported a decline in user engagement.
Imagine if you were a mutual fund manager and owned Meta stock. What would you do? The easy option would be to sell it, take your lumps, and reinvest the proceeds in a stock that looks like less of an uphill battle. That may or may not end up being the best decision, but it would be the easy one. At least, you could stop worrying about it for the time being.
The alternative, of course, would be to hold onto the stock. But that would require having faith that it will recover within some reasonable period of time. I spoke with one investor this week who worried that it might take Facebook as much as five years to rebuild its ad business. Will it take that long? That strikes me as a long time, but right now, it’s anyone’s guess. And that, in a nutshell, is precisely why fund managers have such a hard time making good decisions when it comes to selling stocks.
Further complicating matters: Share prices don’t rise and fall in response to just one issue. Investor sentiment, of course, plays a part in moving stock prices. But that’s not all. Corporate boards, management and shareholders all have levers they can, and do, employ to help move prices. These include:
- Developing new products or acquiring product lines from other companies.
- Spinning off less profitable products or business units.
- Cutting costs, including layoffs and other types of corporate realignments.
- Initiating a dividend or increasing it.
- Initiating or adding to a share buyback program.
- Selling real estate—sometimes accompanied by leasing the property back.
- Settling a lawsuit or government inquiry.
- At the extreme, replacing the CEO or putting the company up for sale.
Sometimes it takes just one of these actions to spark a share price rally. And corporate managers are highly incentivized, via stock options, to do what they can to move their stocks higher. But sometimes it requires outside pressure from shareholders. Activist hedge funds often play this role.
In general, I’m not a fan of hedge funds. But they can play an important role in encouraging companies to take action they previously may have resisted. Carl Icahn, for example, was instrumental in Apple’s decision to initiate large-scale stock buybacks—a move the company initially fought. Icahn was also behind the 2014 push to separate PayPal from its former parent, eBay.
There’s an expression common among investors, that “things are never as good or as bad as they seem.” Right now, of course, things look bad, and so that expression feels a little bit cliché. Vladimir Putin’s actions are appalling, and it’s hard to not feel uneasy. But hopefully this crisis will end sooner rather than later, and with as little loss of life as possible. In the meantime, I think it’s important, when it comes to your finances, to keep your eye on the long term. Try hard to avoid being spooked by bad news. Just as the fate of any company’s share price never hinges on just one factor, the same is true of the overall market.