Picking Stocks Does Not Work

Last Updated August 30, 2023
Picking Stocks Does Not Work

The Allure of Stock Picking

Look, we get it. Nothing beats the feeling of doing solid diligence, finding an undervalued gem, holding onto it for years and years, and watching it 10x market returns. Unfortunately, the data shows that active management (picking stocks) just doesn't work on a reliable basis - and it's not even close. Even amongst career professional portfolio managers, it's extremely unlikely to outperform a passive index fund.

There is a very long history of theory and research on why active management (stock picking) underperforms passive management (diversified funds, ETFs). This post breaks down several recent academic studies on both stock market performance, and also portfolio manager performance, highlighting the conclusions and lessons from the data.

Key Takeaways
  • The vast majority of individual stocks underperform a broad market index fund.
  • A very small percentage of stocks are responsible for most of the gains in the stock market.
  • Similarity, the vast majority of professional stock pickers (fund managers) underperform broad market index funds, and their odds get worse the longer you stick with them.
  • The only reasonable way to invest is making long term investments in broad market index funds. Anything else is incredibly risky.

The Studies

Bessembinder surveys stocks from 1926 to present, finding that the majority of individual stocks actually lose value, that very few are responsible for overall stock market gains, and that over time this concentration effect is getting worse.

  • Of the 28,114 listed firms since 1926, the top performing 110 firms (only 0.4% of all firms) have been responsible for 50% of the total gross wealth creation of the entire stock market.
  • Similarly, since 1926 90% of the total gross wealth creation of the entire stock market has been created by just under 5% of the total firms.
  • That means that the 'worst' performing 95% of all firms are only responsible for only ~10% of the total stock market wealth creation since 1926.

The implications for stock pickers here are obvious: only very small single digit percent of stocks are going to outperform a broad market index. How certain are you that you are going to pick those very few winners? The table below summarizing the research is terrifying.

Bessembinder 2023

This year-end summary published by S&P's reporting arm reviews recent domestic US fund and manager performance. Key findings are:

  • Across all categories, most (50-60%) actively managed funds perform worse than their passively managed benchmark during any given year.
  • Over longer time horizons, the vast majority of actively managed funds perform worse than their passive benchmarks: 79% are underperforming after 3 years, and 93% by 10 years.
  • On a risk-adjusted basis, those numbers get much worse: 83% underperform after 3 years, and 97% after 10 years.

The data here is absolutely devastating. These active funds are managed by highly-compensated professionals, people who have been trading and studying the markets their entire lives. And yet on a 3-year time horizon only 20% of them are able to outperform a passive benchmark, with that number dwindling to almost 5% after 10 years.

S&PGlobal - SPIVA U.S. Scorecard - Year End 2022

Conclusion

The data shows a clear picture where the stock market is driven upwards by a surprisingly few number of firms that vastly outperform the rest. If you are lucky enough to invest in those firms very early, and then also lucky and smart enough to hold onto those investments through the parabolic growth, you'll make a ridiculous amount of money - way more than the market average. But realistically, the data shows that incredibly few people are able to do this. Professional money managers are incredibly highly compensated and should be in the best position to be able to pick winners, it's literally their job, but almost all of them underperform a simple index fund over any timeline.

Picking stocks is incredibly fun, and can be beneficial insofar as it drives you to improve your financial analysis skills, stay informed about the market, etc. But the data clearly shows that the best investment decision you can make is to just buy and hold broadly diversified index funds and ETFs.