Step 3: Stock Pickers

Accept that stock pickers do not beat the market.

3.3.12

Stock Pickers Pay More Taxes

Stock pickers manage their portfolios as if taxes do not matter. The average active manager has approximately a 100% turnover rate per year, while index funds range from 5% to 35%. The cost of turnover is detrimental to the overall performance of the portfolio.

There is a substantial incentive for investors to hold their stocks for a year or more. For stock sales with holding periods of less than one year, the gain is treated as ordinary income and is subject to the full federal and state tax rate.

Depending on the tax bracket and state of residence, this could be 39.6% for federal taxes and 11% for state taxes and can have a dramatic impact on actual returns. For holding periods of one year or more, the tax rate is reduced to the long-term capital gains rate of 15%.

3.3.13

Stock Picking Gurus and Their Real Records

The dangers of stock picking become crystal clear when we focus on the best, brightest, and most famous stars of the investment industry. (More Bad Bets and Big Losses)

Jack Grubman was touted as king of the telecom stock industry in the mid-to-late 1990s. As Salomon Smith Barney's appointed telecom analyst, Grubman was regarded as the most influential power broker in the industry. He was rated number one in Institutional Investor's annual analyst rankings and was profiled by The Wall Street Journal, BusinessWeek, and New York Magazine. When Grubman talked, people listened. If he said, "buy,"; people bought; if he said, "sell,"; people sold. One broker likened Grubman's advice to a narcotic. Everybody wanted it. Salomon Smith Barney's 13,000 brokers passed along his stock picks to their clients. His many monikers included, "Telecom god,"; "Consigliore,"; and "Ax."; At the height of the telecom industry, he gave advice on 40 stocks with a combined market value of more than $1 trillion. He himself made $20 million a year.

Most everyone knows the rest of the story. The glamorous telecom sector soared beyond imagination and then went bust with enormous consequences. Grubman's top 10 picks in March 2001 all plummeted to the lowest of lows a year later. As of May 2002, five of the 10 were trading under $1 a share. Three of the 10 had filed for bankruptcy including Global Crossing, McLeodUSA, and Winstar Communications. Along with the Global Crossing bankruptcy went $55 billion of paper wealth down the drain.

Investors lost millions relying on Grubman's supposed wisdom. The "King of Kings"; lost his seat on the analyst throne and no longer wears the stock picker's crown. When asked what he learned from this disaster, he said, "You learn that even good management teams and macro-industry trends being favorable do not always translate into equity returns being positive." Spoken by the fallen stock picking hero himself.

Financial services firms make money through trading. They take a slice of the pie with every trade. With discount brokerages now in fierce competition, they have reduced their profit margins per trade. In order to maintain the same or greater profit, they must increase the number of trades individuals make. Trading frequently is a high cost activity, not only because of the trade commission paid to the broker, but also because of the spread between the bid and the ask, and the fact that most individuals buy stocks with low expected returns and sell stocks with high expected returns. Brokerage firms are similar to casinos, in that the longer and more often a person plays or trades in the market, the greater the chances that the brokerage firm will make money. The investor's odds of losing unfortunately increase with the frequency of trading. In other words, trading can be hazardous to your wealth.

3.3.14

Stock Pickers Don't Want You to Know the Truth

For many mutual fund managers, analysts, traders, stockbrokers and various other individuals associated with the financial industry, the idea of index funds strikes fear in their hearts. This is because stock pickers and analysts charge very high fees on mutual funds, and these fees pay for a lot of the jobs in the industry. It is in the interest of these stock, time, manager, and style pickers to imply that a market can be beat by listening to their strategist or by risking money with their manager. Who will pay for their cars, houses and yachts? Thousands of jobs in the industry are redundant and completely useless to an investor. As one book from the 1940s asks, "Where are the Customers' Yachts?";

If investors consciously want to gamble, then that is a different story. They can try to outperform the index and their fellow investors if they wish. But, they must realize they will not be able to outperform the indexes for any lengthy period of time. Although they may win a few times at the roulette wheel, they will count themselves lucky, but hardly skillful. After all, if a majority of the gamblers in Vegas actually won, who would pay for all the fancy lights.

3.4

Solutions

Stock prices move randomly and reflect the daily fair market value of each stock. Therefore, the only hope of success for stock pickers is luck or chance. Time and money are too precious to waste on stock picking. The best investment strategy is to own a global, tax-managed, and diversified portfolio of index funds matched to risk capacity. If investments are not on the optimal returns line between risk capacity and risk exposure, then the appropriate market rate of return will not be achieved.

3.5

Summary

Simply put, stock picking is expensive speculation with negative expected returns relative to a blended benchmark. The best advice is to just let go of it, forget about it, stay away from it, and find something more productive to do.

3.6

Review Questions

Please answer the following questions before moving on to the next Step:

1. The performance of stock pickers must be examined on an adjusted basis. When comparing a stock picker's portfolio to an index, which factors must be considered before determining if the stock picker has beat the index?

   a. proper accounting of returns, including cash flows in and out of the account
   b. the exposure to market risk, size risk, and value risk of both portfolios
   c. level of diversification of the two portfolios
   d. standard deviations or volatility measurements
   e. all of the above

2. One of the problems of stock pickers is:

a. They focus on well diversified portfolios.
b. They are focused on the short-term rather than long-term results.
c. They adhere too closely to one style or benchmark.
d. They don't take enough risk.

3. Stock pickers pay more taxes than indexers, because:

a) their annual returns are higher.
b) the average actively managed portfolio has a 45% turnover rate, while index funds range from 5% - 35%.
c) the average actively managed portfolio has a nearly 100% turnover rate, while index funds range from 5% - 35%.
d) they don't pay fees or commissions to their brokers, thereby offsetting the higher taxes.

4. Stock pickers are often compared to:

a) chimpanzees throwing darts at the stock page
b) someone looking for a need in a haystack
c) gamblers atthe roulette table
d) tax generators for the government
e) all of the above

Home

Risk Capacity Surveys

One Hundred IFA Index Portfolios:

Information

IFA Index Portfolio 10

IFA Index Portfolio 20

IFA Index Portfolio 30

IFA Index Portfolio 40

IFA Index Portfolio 50

IFA Index Portfolio 60

IFA Index Portfolio 70

IFA Index Portfolio 80

IFA Index Portfolio 90

IFA Index Portfolio 100

Disclosures for Backtested Performance

Index Funds Advisors, Inc. — 19200 Von Karman Ave., Suite 150 — Irvine, CA 92612
Call Toll Free: 888-643-3133 — Local Phone: 949-502-0050 — Fax: 949-502-0048 — Email:
For several other offices and representative locations, see About Us.

Step 1: Active Investors

Definitions

Problems

Solutions

Step 2: Nobel Laureates

Definitions

Problems

Solutions