Let me introduce you to my friend whom we shall simply call Sammy Stockpicker. Sammy and I meet regularly over a cup of coffee at Peet’s. Sammy is a very accomplished individual. An engineer by training, Sammy holds a Ph.D. from a top school and is a successful Silicon Valley executive. Knowing my background, Sammy insists on talking about his success in stock picking. He just can’t help it. With a gleam in his eye, he often reminds me about his forecasts on a wide range of tech stocks. If a market surge had just preceded our meeting, Sammy would become quite the market strategist, extending his expertise to all manner of investments from commodities, to real estate, to Bitcoin. Being the good friend that I am, I rarely remind Sammy about his spectacular failures—like the time he called for a short on stock x or stock y, which then promptly proceeded to double or triple in value. I just humor Sammy.
Now let us admit it, there is a bit of Sammy in all of us. Who can resist the urge to buy a “hot” stock? The desire to make a quick buck is all too human. But before we bet the house on our favorite stocks, let us consider this. The majority of the best trained, most accomplished professional money managers often make mistakes in their stock picks. Numerous studies have shown that an overwhelming percentage of mutual fund managers fail to beat their benchmarks after accounting for fees and transactions costs.
A splendid paper by Bill Sharpe, Emeritus Professor at Stanford and the 1990 Nobel Prize winner in Economics titled, “The Arithmetic of Active Management” (Financial Analysts Journal, January/February 1991), explains why. What is the market? The market is nothing but the sum of all its participants. In other words, it is the collective securities held by mutual funds, institutions, endowments, and individual investors like us. If the sum of all our holdings equals the market, on average what is our return? Zero. In fact, if you consider the brokerage fees and commission of buying or selling a stock, or the fees charged by a professional money manager, what you are left with is, on average, the market return minus these costs. This does not mean that there isn’t a reliable way to outperform the market but does illustrate powerfully what a difficult game beating the market is. On a truly long-term basis, few investors can claim to have consistently outperformed the market. Equally difficult is the ability to correctly pick managers who will beat the market going forward. Past outperformance, as they say, is no guarantee of future outperformance.
Analyzing the returns of pension plans, Brinson, Hood, and Beebower (Financial Analysts Journal, January/February 1995) demonstrated that over 90% of return variation in a portfolio is determined by asset allocation decisions. In other words, which asset class you are invested in is more important than which stock or fund you picked. Even if you are an excellent stock picker in a declining stock market, you are still going to lose money. And on average, stock picking does not contribute significantly to your portfolio’s performance.
Benjamin Graham wrote in The Intelligent Investor (Harper Row, 4th ed. 1973), “There is intelligent speculation as there is intelligent investing. But there may be ways in which speculation may be unintelligent. Of these, the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.”
Luckily my friend Sammy is all talk. He is quite sensible about money and he rarely picks individual stocks or bonds. He has paid off his mortgage, put aside money for his children’s education, and lets the pros invest for him. He even makes sure that I pay for my own coffee.
You should do the same.
Prabhu Palani, CFA, was formerly a managing director and the head equity strategist at Mellon Capital Management in San Francisco, CA. Previously he was senior vice president and portfolio manager at Franklin Templeton Investments and Principal, Portfolio Manager at Barclays Global Investors. Prabhu holds graduate degrees from Stanford University and the University of Delaware and is a member of the CFA Institute and the Institute of Chartered Accountants of India.