THE “STOCK PICKER’S MARKET” FALLACY

One of the most misused and destructive phrases in the investment world is the notion of a “stock picker’s market.” Depending on the market environment, it is used in different ways, but all generally incorrect.

In a relentless uptrending market, investors become highly confident in their ability to pick stocks, naturally calling it a “stock picker’s market.” After all, any stock they pick is going “up and to the right.” We saw the most extreme example of this in 2013, which set a record in terms of breadth with 93% of stocks in the S&P 500 finishing positive on the year. Never mind the fact that a blindfolded monkey throwing darts was likely to pick a winning stock last year; most investors came out of 2013 believing they were the next Warren Buffett.

In a sideways or down market as we are observing this year (52% of stocks in the S&P 500 are positive as of 4/11), the financial media throws out the term “stock picker’s market” to keep investors interested in the game. You just need to “do your homework,” they say, and separate the wheat from the chaff. After all, “there’s always a bull market somewhere.” While there is some truth to this phrase, the question is whether most investors can find that “bull market” with any consistency. Regrettably, all studies I have seen on this subject show that they cannot. On average, investors are notoriously poor traders and stock pickers and would fare much better spending their time on more boring concepts such as risk tolerance, asset allocation and rebalancing.

One of the primary reasons why investors are poor stock pickers has to do with behavioral finance. Armed with no methodology, investors naturally rely on their emotions to make decisions. For these investors, “doing their homework” means simply finding the stocks that have done the best in the most recent past (recency bias), are most popular (herding), or are recommended/owned by gurus and wall street analysts. Unfortunately, these are all terrible reasons for buying a stock.

At the end of last year, if you knew nothing about investing and wanted to pick a stock, you would have likely gone with one of the best performers in 2013. How would this strategy have performed? The Top 25 performers in 2013 are down an average of -2.1% this year, undperforming the S&P 500 (SPY). The two best stocks in 2013, Netflix (NFLX) and Best Buy (BBY), are both showing double digit losses.

Alternatively, you may have chosen a stock because some prominent hedge fund was in the name, uncovering this information from lagged 13F filings. This methodology would have performed even worse as measured by the Global X Top Guru ETF (GURU) which pursues such a strategy. GURU is down -8% YTD, substantially underperforming the market.

On the other hand, how many investors would have selected a stock from the bottom 25 performers of 2013, all of which were down last year and hated by Wall Street analysts? My guess is not many but if they had, they would have fared much better, with an average return of 6% thus far in 2014. The worst two stocks in the S&P 500 in 2013, Edwards Lifesciences (EW) and Newmont Mining (NEM), are both positive this year. A simple strategy that would have went long the bottom 25 performers and short the top 25 performance of at the end of 2013 would have been up over 8% this year.

Overall, most investors would do well to ignore the allure of “stock picking” and any notion that they have an innate ability to pick winning stocks. I know this may be hard to accept but it should be somewhat easier when you look at the performance of most institutional stock pickers who suffer from the same behavioral foibles. This is not to say that it is impossible pick winning stocks as there are certainly great stock pickers in existence. However, the casual investor with no process or strategy is highly unlikely to be among them. It is never a “stock picker’s market” for these investors.

Fortunately, though, stock picking is not a prerequisite to successful investing. In fact, it is the antithesis of successful investing for many. For most investors, instead of “doing their homework” in trying to find the next Google or Apple, they should be developing an appropriate asset allocation plan and sticking to it. While not as exciting as jumping aboard the latest 3D printing or biotech breakout, it is likely to be significantly more profitable in the long run.