All about investments, personal finance and well-being! But almost always based on academic research.
It is time to analyze one of the most popular investment strategies in the world: Stock Picking. In case you don't know, stock picking corresponds to forming a portfolio of shares chosen by you or by a financial advisor (portfolio with 5, 10, 20 or more shares that you or your advisor believe will perform well in the future ). The goal is to pick the best stocks and not own those that, based on your analysis, you think will perform poorly in the future. This way you can get more profit than the whole market because you have the best stocks and you eliminated the worst ones. But, have you ever wondered if that's true? What do statistics and academic studies say about stock picking? In this article we will look at this in detail from an academic perspective.
In order to know how good our odds are when it comes to choosing those stocks that will beat the market, we need to know what percentage of total stocks beat a given market.
The statistics of "Stock Picking"
The paper “Do Stock Prices Outperform Treasury Bills?” (Henry B; 2018) concluded that, from 1926 to 2017, 4% of US stocks explain the return of the ENTIRE US stock market. The remaining 96% collectively only equals the return of a US Treasury bond. This means that, in order to beat the market, you have to pick that little 4% of stocks over and over again (the stocks that comprise that 4% change over the years, so you have to find them over and over again). If you are unlucky enough to keep many or all of the remaining 96%, well, in the long run, you will get the same return as owning a treasury bond. Unfortunately, stock picking is like finding a needle in a haystack several times in a row, the odds are not in your favor (and we are not considering the work involved in analyzing thousands of different stocks, counting the ones that constantly come up).
But that's just the USA, there are hundreds of other countries. Perhaps you are a more developed investor and have already understood the importance of international diversification. Are your chances of stock picking better if you have international exposure? Unfortunately not.
The paper "Do Global Stock Prices Outperform Treasury Bills?" (Henry B. et al; 2019) analyzed this, studying the returns of 62,000 shares around the world (approximately 44,000 outside the USA) from 1990 to 2018. This number of shares represents 87% of the entire market. Some of the main conclusions are:
- The 5 best stocks in the sample (0.008% of the total) explain 8.27% of all net wealth creation in the world in the period studied.
- The best 306 stocks (0.5% of the sample) explain 73.03% of all global net wealth.
- Outside the USA, the results are even stronger. It was found that 111 international stocks (0.25% of the total), explain 69.2% of all international net wealth creation (not including the US).
- 93.79% of the creation of international net wealth is explained by 221 international actions.
- Less than 1% of all international stocks explain all wealth generation outside the US from 1990 to 2018.
- If we consider the USA, it was concluded that the entire generation of net wealth from 1990 to 2018 is explained by 1.3% of all the stocks in the world that were studied.
Your chances of consecutively and consistently picking that 1.3% of shares is VERY low, this is not counting the work that is required and assuming that you are able to shut out the 98.7% of the shares that, collectively, they do not generate more than a US treasury bond.
You also have to consider that it will be almost impossible for you to know in advance if one or more of the actions you have chosen is or is not a needle in the haystack. This is because, in the short term, stock returns are almost random. For this reason, a stock that one day will be in that small 1.3% can give bad results for years and a stock that, in the future, will not give more than a US treasury bond, can give great profits in a certain year.
Now you know the statistics of stock picking, but we still have to explore one last angle: psychology.
The Psychology of "Stock Picking"
There are 2 psychological phenomena that affect all people equally and that we cannot avoid having: The confirmation bias and the "Endowment effect".
Confirmation bias is the tendency to search for and consider more intensely and selectively information that confirms what we already think. Therefore, we interpret more positively those facts that support our previous opinions.
In the investment world this bias is very present. If you own a portfolio of select stocks and get huge returns in a year or over several years, you might start to think that those results are due to your excellent ability to choose assets, even though in reality, those results are simply the result of chance (yes, you can beat the market for years with just luck, but sooner or later you fall).
For its part, the "Endowment effect" refers to the fact that people give a higher value to the object they own as opposed to the value they would give to that object if they did not have it. In other words, we tend to overvalue what we already have, just for the sake of having it.
The implication of this effect in the investment world is clear. People tend to overvalue those investments they have and disparage (or ignore) those they don't own because they don't own them. Stock pickers often become emotionally attached to the stocks they own, preventing them from making decisions based on statistics.
We now know that about 1.3% of world stocks account for all of the world's wealth generation. The remaining 98.7% of shares alone give, collectively, the same as a US Treasury bond over the long term. In addition, confirmation bias and the "endowment effect" cloud our judgments and lead us to make decisions based on emotions and not data.
As we can see, investing in a portfolio of stocks chosen by you or someone else is like finding a needle in a haystack over and over again. It just can't be done and it's not reasonable.
So what can we do?. If you can't find the needle in the haystack, you must buy the entire haystack (we'll cover this in future articles).
I hope you liked my article, I will be happy to read any comments. Stay tuned because little by little I will write more about the world of finance and investments.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2022 Nicolas Hidalgo