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Stock Picking

Can an active investor or money manager out-perform stock market rates of return by picking or trading individual stocks?

In the graph below you will see that few outperforming stocks may account for a disproportionately large share of the US market’s return in a given year.  If the top-performing decile of stocks were excluded each year, the market’s return would drop to 6.3%.  Excluding the top 25% of performers each year would reduce the market’s average annual return to a negative -0.5%.

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Since it is impossible to reliably identify winners before the fact, the most prudent approach is to maintain broad diversification and consistent exposure within a particular asset class.  This improves the likelihood that a portfolio will capture outperformance wherever it may occur.

Active stock pickers believe that they can pick the best stocks of asset classes and do better than the asset class as a whole.  As you can see from this next chart the vast majority of active mutual fund managers have failed to pick the best stocks and beat the market.

 

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This chart also tells us that some active managers were able to beat the market.  Because of this fact we are lead to ask, was it luck or skill?

To answer this question we took the 30 top-performing active mutual funds from 1990 to 1999.   These 30 active funds delivered significantly higher returns, 27.15 percent versus the S&P 500 of 18.89 percent.5  How well do you think these same top 30 funds did over the next 10 years, from 2000-2009?  These 30 funds delivered lower returns, negative -4.43 percent versus the S&P 500 benchmark did 1.21 percent.They all underperformed the Market as a whole. The answer to the question is; active fund manager who beat their index just had luck.

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1 Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 30, 2010.  Indices used for comparison:  US Large Cap–S&P 500 Index, US Small Cap-S&P 600 Index, International – S&P 700 Index, International Small – S&P Developed ex. -US Small Cap Index, Emerging Markets – S&P IFCI Composite.  Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database.  Results are net of fees and expenses.  Indices are not available for direct investment.  January 1, 2005 – December 31, 2009

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