Merton Miller

"If there's 10,000 people looking at the stocks and trying to pick winners, one in 10,000 is going to score, by chance alone, a great coup, and that's all that's going on. It's a game, it's a chance operation, and people think they are doing something purposeful...but they're really not."

— Merton Miller

Michael Jensen

"Very little evidence [was found] that any individual [mutual] fund was able to do significantly better than that which we expected from mere random chance."

— Michael Jensen, “The Performance of Mutual Funds in the Period 1945-1964,” Journal of Finance, 1968

Ron Ross

"Active management is little more than a gigantic con game."

— Ron Ross, The Unbeatable Market, 2002

Anonymous

"By day we write about 'Six Funds to Buy NOW!'... By night we invest in sensible index funds. Unfortunately, pro-index fund stories don't sell magazines."

— Anonymous, Fortune Magazine, 1999

Introduction

The Big Casino
The Big Casino

One of the potholes in the road that jolts investors off the recovery wagon is also a glamorous aspect that attracts them to active investing in the first place: Stock Picking. The term is pretty self-explanatory. As The Big Casino painting illustrates, stock picking is the same as throwing dice and hoping for the big bucks—sheer gambling. What's not to like about stock picking? You have stock picker thespians like Jim Cramer appearing in Hollywood blockbusters, such as Iron Man, where he plays the same role he does on his highly rated cable TV show. One should ask themselves, "Are they both acts?" Then there is Wall Street, a movie depicting a high octane, push-it-to-the-limit lifestyle that seems exciting and a bit dangerous in a cool kind of way. The real danger occurs when investors are influenced by the speculative stories and recommendations these stock pickers throw around.

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Stock Pickers Fail

Stock prices are quickly moved by news that is available to all market participants at the same time. Because news is utterly unpredictable and random by nature, we come to the unavoidable conclusion that movements of stock prices are also unpredictable and random. Therefore, the current stock price is always the best estimate of the stock's fair price. This means those celebrity stock pickers appearing on television and the silver screen are no different than a team captain calling a coin toss before a big game. It's a blind guess as to whether the stock will go up or down in the short term because these events will occur based on news that is unknowable in advance. This means your portfolio, if based on a few hand-picked stocks, will rise or fall on the whims of the daily news.

Ever since the first stock market trade, traders have been looking for ways to predict future stock market movements. They have studied reams of data, looking for patterns in the prices of securities. In 2000, a Nova television special, "The Trillion Dollar Bet,"1 reported that a group of academics in the 1930s decided to find out if traders really could predict how prices moved. Since they could not find any scientific basis for the belief, they decided to run a series of experiments. In one of them, they created a random portfolio of stocks by throwing darts at The Wall Street Journal while blindfolded. After one year, they were stunned to discover the dartboard portfolio had outperformed the portfolios of Wall Street gurus. The academics arrived at a devastating conclusion: The success of top traders was simply due to luck, and patterns in prices appeared by chance alone.

In 1992, 63 years after the stock market crash, John Stossel of ABC's 20/202 program conducted some follow-up research on the dart throwing. He determined the economists' findings from more than six decades prior remained true. Stossel interviewed Princeton Professor Burton Malkiel, author of A Random Walk Down Wall Street. Professor Malkiel reminded viewers that stock markets have historically delivered a performance of 9.5% to 10% per year. "To beat the average, should an investor listen to the Wall Street professionals?" Stossel asked. "No," replied Malkiel. "All the information an analyst can learn about a company, from balance sheets to marketing material, is already built into the stock price because all of the other thousands of analysts have the same information. What they don't have is the knowledge that will move the stock such as news events, which are unpredictable and impossible to forecast."

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Lack of Market Knowledge

Baked in the Cake
Baked in the Cake

Stock pickers presume there are mispriced stocks that can be identified in advance and exploited for profit. They don't realize that virtually all of the information about a stock, a sector, or an economy is very quickly digested by the totality of market participants and swiftly embedded into the price. This market efficiency ensures the prices agreed upon between willing buyers and willing sellers are the best estimate of fair market values. In other words, available information and news is "baked in the cake," meaning nobody has access to anything "special" that is not already included in the price, unless investors have inside information. No single trader can know more or have a consistent advantage over the millions of other market participants around the world. Markets reward investors, not speculators.

Tenets of market efficiency do not state that at any given time there are no mispriced securities in the marketplace. Rather, these tenets assert that because prices reflect all known information, mispriced securities cannot be identified in advance.

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Stock Pickers' Poor Behavior

Stock pickers are very confident, harboring biases about their abilities to pick winning stocks. In a study titled, "Are Investors Reluctant to Realize Their Losses?,"3 Terrance Odean, professor of finance at the University of California, Berkeley, analyzed the activity of 10,000 discount brokerage accounts. Odean's findings, published in the October 1998 issue of Journal of Finance, showed that investors habitually overestimated the profit potential of their stock trades. In fact, they would often engage in costly trading, even though their profits did not even cover their transaction costs. Odean's research showed investors believed they had unique information which would give them an edge, when in reality they operated under widely disseminated information. On average, the stocks investors bought underperformed the stocks they sold.

In a follow-up paper, "Trading is Hazardous to Your Wealth: The Common Investment Performance of Individual Investors,"4 Odean joined Brad Barber of University of California, Davis to analyze 66,465 individual trading accounts. They found that from 1991 to 1996, investors who traded most earned annualized returns of 11.4%, while in the same period the market earned annualized returns of 17.9%. The tendency for these investors to trade excessively resulted in an erosion of returns compared to the market.

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A Stock Picker's Defeat

Even professional stock pickers can fall hard. One infamous story shows how a former Morningstar "Fund Manager of the Decade"5 lost his Midas touch after a well known winning streak. Bill Miller's Legg Mason Value Trust Fund (LMVTX) is portrayed in Figures 3-1, 3-2 and 3-3, showing the risk and return results of his fund for three different time periods, compared to various indexes and index portfolios: Figure 3-1 for the decade of the 90s through 2000; Figure 3-2 for the ten years from 2001 to 2010; and Figure 3-3 for the 30 years and 8 months since the inception of the LMVTX fund.

As the first chart clearly shows, LMVTX did earn higher returns than the S&P 500 and the index portfolios during the 90s, but with significantly higher risk—a risk that eventually caught up with Miller. In a January 6, 2005 article in The Wall Street Journal, Miller accounted for his winning streak saying, "As for the so-called streak, that's an accident of the calendar. If the year had ended on different months it wouldn't be there. At some point, mathematics will hit us. We've been lucky. Well, maybe it's not 100% luck—maybe 95% luck."6

Figure 3-1

Figure 3-2 shows just how hard the mathematics did hit Miller. Despite the fact that his "so-called streak" showed him to outperform the S&P 500 for a 10-year period, Miller's subsequent 10-year returns from 2001 to 2010 pale in comparison to the indexes and index portfolios shown. Miller's outperformance and subsequent underperformance were the result of his excessively risky bets on concentrated investments among highly correlated stocks. While equity index portfolios invest across many asset classes and invest in as many as 12,000 companies in 40 different countries, Miller's strategy was to "place big bets on stocks other investors feared," cites a Wall Street Journal article, "The Stock Picker's Defeat." According to the December 2008 article, "Mr. Miller was in his element [a year ago] when troubles in the housing market began infecting financial markets. Working from his well-worn playbook, he snapped up American International Group Inc., Wachovia Corp., Bear Stearns Cos. and Freddie Mac. As the shares continued to fall, he argued that investors were overreacting. He kept buying." The article continued, "What he saw as an opportunity turned into the biggest market crash since the Great Depression. Many Value Trust holdings were more or less wiped out. After 15 years of placing savvy bets against the herd, Mr. Miller had been trampled by it." Miller stated, "The thing I didn't do, from Day One, was properly assess the severity of this liquidity crisis… I was naive… Every decision to buy anything has been wrong… It's been awful."7 Not only did the assets themselves plummet, but investors bailed on the fund pushing its assets down from its apex of $21 billion to around $4.2 billion.

Figure 3-2

At one point Miller said, "The S&P 500 is a wonderful thing to put your money in. If somebody said, I've got a fund here with a really low cost, that's tax efficient, with a 15 to 20-year record of beating almost everybody, why wouldn't you own it?"8

Figure 3-3 shows that over the lifetime of the LMVTX, several indexes and index portfolios outperformed the LMVTX with lower risk than the LMVTX, and the more appropriate benchmark of U.S. Large Cap Value beat Miller with less risk.

Figure 3-3

Miller's so-called streak was based on bad benchmarking. LMVTX was far riskier than the S&P 500, a reality most investors certainly did not understand—especially investor Peter Cohan who lamented to the Wall Street Journal, "Why didn't I just throw my money out the window and light it on fire?"9

Morningstar ranked Miller's fund as one of the top 3 losers for fund performance in June 2011. Bloomberg News reports that Russel Kinnel, Morningstar director of mutual fund research said, "People assume because certain managers have had good streaks that they are always going to be a step ahead of the market. It never works out that way."10

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Stock Pickers' Graveyard

The media loves a good story. Who can blame them? It's their job to present the latest and greatest news. So when a stock picker happens upon a sector that turns red hot, the media adorns this lucky stock picker with guru status—until, of course, that red-hot sector turns cold and the guru torch is handed over to the next lucky stock picker. In fact, the stock picking graveyard is crammed with wildly successful stock pickers and companies who have perished from the exchanges.

The financial press largely focuses on the daily movements of stocks and markets, showering rewards on those who are lucky enough to be in the right place at the right time. But luck is not a repeatable skill. This reality is clearly spelled out in Mark Hulbert's 2008 New York Times article, "The Prescient are Few."11 Hulbert details the findings of a study12 by Professors Laurent Barras, Olivier Scaillet and Russell Wermers about the performance of 2,076 mutual fund managers over a 32-year time period. It found that from 1975 to 2006, 99.4% of these managers displayed no evidence of genuine stock picking skill, and the 0.6% of managers who did outperform the index were "statistically indistinguishable from zero," or as Hulbert puts it, "just lucky." Figure 3-4 depicts the study's results.

Figure 3-4

A statistical test called the Student's t-test was introduced in 1908 by William Sealy Gosset, referred to as the "Student," while working for the Guinness brewery in Dublin, Ireland to evaluate the quality of the brewery's ingredients. The t-test can be used to determine if a series of historical returns is reliably superior–showing a t-statistic of 2 or higher–to a risk-equivalent benchmark. This can determine whether alpha (any return above the benchmark return) is due to luck or skill. In Figure 3-5, the t-test is applied to U.S. equity funds in six different style classifications over a 20-year period. Out of 237 mutual funds constructed with at least 90% U.S. equities, 99.0% of those fund managers did not have a statistically significant alpha, meaning any alpha they did have was due to luck, not skill. See the Step 5 Solutions section for a further explanation of the t-stat.

Figure 3-5

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Looking for a Needle in a Haystack

Needle in a Haystack
Needle in a Haystack

Everyone wants to find the next Google or Apple, but picking a stock that will do better than the market index over the long haul is virtually impossible. Vanguard Group founder John Bogle has accurately described the practice of stock picking as "looking for a needle in a haystack." Even if you are lucky enough to pick a stock that outperforms the market, there is no certainty of success, or even survival, in the future.

In their book, Creative Destruction,13 McKinsey & Company consultants Richard Foster and Sarah Kaplan analyzed the companies of the original S&P 500 Index from 1957. Their findings shown in Figure 3-6 revealed that only 74 companies remained on the list in 1997, and just 12 of them ended up with returns that outperformed the index for the 41-year period through 1998. "As the '80s passed and we made our way through the ‘90s, both of us observed that almost as soon as any company had been praised in the popular management literature as excellent or somehow super durable, it began to deteriorate," the authors wrote. "Searching for excellent companies was like trying to catch light beams; they were easy to imagine, but so hard to grasp," they concluded.

Figure 3-6

Figure 3-7 takes stock pickers for a short walk down Misery Lane, reminding them of the twenty largest bankruptcies from January 1981 through December 2013. Few industries escaped, as companies such as Lehman Brothers, Washington Mutual, GM, and MF Global Holdings ultimately failed and succumbed to bankruptcy. The number of bankruptcies dramatically increased from 19,695 in 2006 to 47,806 in 2011.

Figure 3-7

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Great Companies Don't Make Great Investments

Remember Peter Lynch's advice about buying companies whose products you like? It turns out this advice is not as good as it sounds. Great companies don't make great investments. You may love Apple's iPad, but this doesn't mean Apple is a great stock to buy. In fact, the opposite is usually true. Distressed companies have earned higher returns than those of companies with lots of hype or goodwill. Unfortunately, investors generally avoid investing in distressed companies, because it seems counterintuitive to buy perceived losers.

Finance Professors Meir Statman and Deniz Anginer wrote a 2010 study called "Stocks of Admired Companies and Spurned Ones."14 Their study was based on Fortune Magazine's annual list of "America's Most Admired Companies" from 1983 to 2007. Fortune's annual surveys ranked companies on eight attributes of reputation:

  • Quality of management
  • Quality of products or services
  • Innovativeness
  • Long-term investment value
  • Financial soundness
  • Ability to attract, develop and keep talented people
  • Responsibility to the community and the environment
  • Wise use of company assets

From these ratings, Statman and Anginer constructed two portfolios, each consisting of one half of the Fortune stocks. The "admired" portfolio (often referred to as growth stocks) contained the stocks with the highest Fortune ratings, and the "spurned" portfolio (often referred to as value stocks) contained the stocks with the lowest Fortune ratings. For example, the list of admired companies included The Walt Disney Company, UPS and Google. Spurned companies included Jet Blue, Bridgestone and Stanley Works.

The results of the study are of no surprise to value investors. "Stocks of admired companies had lower returns, on average, than stocks of spurned companies." Figure 3-8 shows the 16.12% annualized return of the spurned portfolio and the 13.81% annualized return of the admired portfolio over the 24-year, 9-month period.

Figure 3-8

Why have value stocks delivered higher returns to their investors? The market perceives value companies to be riskier, driving down stock prices so their expected returns are high enough to attract investors. That is difficult for most investors to grasp since they prefer to believe growth stocks are better investments than value stocks. After all, investors looking for a stock tip want to hear the name of the next Apple, not the next JCPenney. As you will see in Step 8, the data indicates that investors should be interested in great investments (value stocks), not just great companies (growth stocks).

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Fortune Kookie

I analyzed Fortune's "Ten Most Admired Companies" (2001) as a whole portfolio and as individual companies, comparing them to ten index portfolios for the 13-year period from January 2001 through December 2013. Please note that there are now only nine of the original ten companies since one of them (Dell) went private. The results of the study are shown in Figure 3-9, indicating the equal-weighted "Fortune Most Admired Portfolio" significantly underperformed every index portfolio—even Index Portfolio 30 which has 70% fixed income. Despite the fact that the "Fortune Most Admired Portfolio" carried slightly higher risk than the riskiest Index Portfolio 100, it yielded $174,456 on a $100,000 investment for the time period vs. a return of $314,006 for Index Portfolio 100. The story gets worse for the "Fortune" tellers. Three of the nine ended up with a negative return for the period. Even Warren Buffett's widely touted Berkshire Hathaway stock failed to compensate investors for risk, closely delivering the returns of an Index Portfolio 60, despite the fact that it took comparable risk to Index Portfolio 90.

Figure 3-9

This sort of data begs the question: If stock picking is such a fruitless endeavor, why do magazines keep selling this elusive dream? The answer is quite basic: Pro-index funds stories don't sell magazines. No big brokerage house would take out a full-page ad that says, "Don't hire us to trade your portfolio—just index and relax." Nonetheless, this is a poor reason to perpetuate the myth that financial journalists or "Fortune Tellers" can pick the handful of stocks to achieve wealth. In fact, by the looks of it, the best way to lose a fortune is to follow Fortune.

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Bond Pickers

The benefits of passive investing also apply to the fixed income portion of an investor's portfolio. There is a pervasive
falsehood that while the stock market may be efficient, the bond market is a different story. This myth has been negated over the years. The first major study of bond funds was conducted by Blake, Elton, and Gruber and was called "Fundamental Economic Variables, Expected Returns, and Bond Fund Performance."15 It examined 361 bond funds for the period starting in 1977. They compared the actively managed bond funds to a simple index alternative. The results of the study are that the actively managed bond funds underperformed the proper benchmark by an average of 0.85% year, before federal and state taxes.

Another study is the Standard & Poor’s Indices Versus Active (SPIVA®) Scorecard, a methodology designed to provide
an accurate comparison of active versus passive funds. Of 13 different categories of bonds analyzed by SPIVA for the 5-year period from 2007 through 2011, not one of them had a majority of funds that outperformed the benchmark. In total, only 162 (or 18.1%) of the 895 funds analyzed beat their benchmark. The average level of underperformance was 1.55%. The primary reason for this underperformance is the drag of the management fee expenses and the internal expenses of running the fund. Figure 3-10 displays 11 of the 13 fund categories analyzed. The only reason two of the categories are not shown is simply due to page size and space constraints. The two missing categories represent: 1) 93 investment-grade long funds (active) vs. the Barclays long government/credit index with results showing that 90 (or 96.8%) of the investment-grade long funds underperformed the Barclays index; and 2) 45 government short funds vs. the Barclays 1-3 year government index, showing that 30 (or 66.7%) of the government short funds underperformed the benchmark. No matter how you slice it, it appears that passive beats active.

Figure 3-10

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Solutions

Looking for a needle in a haystack is not the answer. Picking stocks or bonds is an ill-fated pursuit that wastes time, energy and money. Would you bet your money in Vegas because you have a gut feeling the roulette ball will land on 12-black? You know by now that it is impossible to predict the future.

The better solution is to buy the haystack, keep costs low and maintain risk-appropriate exposures in globally diversified index portfolios.

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Footnotes:
  • 1Nova, The Trillion Dollar Bet, Documentary, Lauren Aguirre (2000; Arlington: Public Broadcasting Service.), Television.
  • 220/20, Who needs the Experts?, Documentary, John Stossel (1992; New York: ABC News.), Television.
  • 3Terrance Odean, "Are Investors Reluctant to Realize Their Losses?," The Journal of Finance, vol. 53, no. 5 (1998).
  • 4Brad M. Barber and Terrance Odean, "Trading is Hazardous to Your Wealth: The Common Investment Performance of Individual Investors," The Journal of Finance, vol. 55, no. 2 (2000).
  • 5Diana Cawfield, "Manager Monitor: Bill Miller," Morningstar, Nov. 2, 2002, http://www.morningstar.ca/globalhome/industry/managermonitor.asp?reportid=187.
  • 6Ian McDonald, "Bill Miller Dishes On His Streak and His Strategy," Wall Street Journal, Jan. 6, 2005.
  • 7Tom Lauricella, "The Stock Picker's Defeat," Wall Street Journal, Dec. 10, 2008.
  • 8Kirk Kazanjian, Wizards of Wall Street (Paramus, NJ: Prentice Hall, 2000)
  • 9Tom Lauricella, "The Stock Picker's Defeat," Wall Street Journal, Dec. 10, 2008.
  • 10Charles Stein, "Berkowitz Leads Top Stock Pickers Hitting Bottom as Growth Slows," Bloomberg News, June 12, 2011.
  • 11Mark Hulbert, "The Prescient are Few," New York Times (New York, NY), Jul. 13, 2008.
  • 12Laurent Barras, Olivier Scaillet and Russ Wermers, "False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas," The Journal of Finance, vol. 65, no. 1 (2010).
  • 13Richard Foster and Sarah Kaplan, Creative Destruction: Why Companies that are Built to Last Underperform the Market-and How to Successfully Transform Them (New York: Doubleday, 2001).
  • 14Meir Statman and Deniz Anginer, "Stocks of Admired Companies and Spurned Ones," Santa Clara University Leavey School of Business, Research Paper No. 10-02 (2010).
  • 15Edwin Elton, Martin Gruber and Christopher Blake, "Fundamental Economic Variables, Expected Returns, and Bond Fund Performance," Journal of Finance, vol. 50, no. 4 (1995).
step 3stock pickingstock pickersburton g. malkiela random walk down wall streetmarket efficiencybaked in the caketerrance odeanjournal of financeoverestimatetrading is hazardous to your wealthbrad barbertradingbehaviormorningstarlegg masonlmvtxs&p 500bill millermark hulbertskillalphat-testluckmutual fundst-statneedle in a haystackcreative destructionjohn boglemeir statmandeniz angineradmiredspurnedpeter lynchfortune magazinefortune tellersten most admired companieswarren buffettberkshire hathawaybond pickersspivastock picking solutions

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