I have little confidence in the ability of stock pickers to consistently outperform the simple and low-cost investment approaches pioneered by the recently passed Jack Bogle of Vanguard.
Although there are instances of stock pickers and mutual funds who beat the market, the majority of actively managed mutual funds underperform benchmarks after fees. It has become harder and harder over time to beat the market, as the free flow of data and information makes the “game” ever more competitive.
The most recent scorecard from S&P Dow Jones found that over the trailing 15-year period, roughly 19 out of 20 actively managed U.S. mutual funds lagged their benchmarks. Moreover, of those who do outperform benchmarks, there is little data to suggest that they can repeat their performance. In essence, any “skill” that shows up in the data may in fact just be luck.
However, new research out of the University of Chicago says that active managers and stock pickers may actually be pretty good at identifying when a stock is undervalued. That is, they’re good at identifying buying opportunities. On the other hand, the research suggests that managers are really bad at knowing when to sell. It is this lack of success in knowing when to sell that ultimately leads to their collective underperformance.
Successful stock pickers must know both when to buy and when to sell. The new research posits that fund managers dedicate a lot of time and resources to identifying buying opportunities, but little time and resources figuring out when to sell. The paper asserts that stock pickers may actually do better if they randomly decided when to sell instead of making active decisions. Professional and amateur investors alike suffer from cognitive biases that negatively impact their ability to make objective selling decisions.
This brings up a discussion I’ve recently been having with investors about the difficulty of market timing in general. Even if you correctly predict when to bail out of the stock market and avoid a downturn, you also have to correctly decide when to get back in to capture the upside. Too often, I see people get out of stocks before a market drop, but fail to get back in until the market has already risen past its previous highs. Typically, these investors would have been better off doing nothing at all.
This is one reason programmatic investment plans tend to be most successful. Contributions to a 401(k) plan are a good example. People establish regular contributions to a plan and an asset allocation that is likely to remain unchanged for years at a time. Investors who don’t bother to check their balance every day end up doing better than those who obsess over daily or monthly fluctuations and try to guess what will happen next.
Every investment decision has two sides – when to buy and when to sell. Active managers may be good at finding buying opportunities, but they seem to lose their discipline when it comes to selling. Similarly, market timers sometimes are able to figure out when to get out of a market, but are often left on the sidelines as the market sets new highs.
All humans, whether professional money managers or amateur stock pickers, are subject to cognitive biases that too often override objectivity. My prescribed solution is to establish a prudent and disciplined plan and maintain that plan for many years instead of reacting to headlines or the predictions of supposed experts.