Of all the nonsensical terms that pervade the financial media, there are few that reach the stupidity level of "a stock picker's market." It is a refrain often heard at the beginning of the year, particularly when the stock pickers (i.e., active mutual fund managers) of the prior year turned in a dismal performance, as they did in 20111 and 20122. The pundit who proclaims it means to say that stocks are not expected to move together as much as they normally do, and therefore a talented stock picker will be richly rewarded for separating the wheat from the chaff. How the pundit would know the future behavior of individual stock returns relative to each other is unfathomable to both himself and his audience.
The underlying reason for the fallacy of a stock picker's market is that regardless of the correlation among individual stock returns, one stock picker can only benefit at the expense of another stock picker. As a group, all the stock pickers together receive the return of the market and after accounting for their expenditures resulting from their stock picking activities (e.g., research and trading costs), their return is well below the overall return received by passive investors who also get the market return but at a much lower cost.3 The crux of this idea, as formulated by Nobel laureate William Sharpe, is that regardless of whether or not markets are efficient, active management is a loser's game.
A reasonable question to ask is just how good of a stock picker do you need to be to beat the index after covering your costs? The chart below gives a fair indication. It shows the bell-shaped distribution of the 2012 returns of the 491 companies that were in the S&P 500 Index for the entire year. Note that while the return of the S&P 500 Index was 15.84%, the average large blend fund had a return of 14.96% (source: Morningstar.com). A stock picker striving for a respectable alpha of 2% after covering costs of 1% would have to land the majority of his picks to the right of the middle bar (the 120 stocks that returned between 10% and 20%). The number of individual stocks delivering a return higher than 20% was 178, or 36% of the population. Our would-be star stock picker would have to be quite lucky to have his picks concentrated among these companies. Of course, this assumes that the stocks were picked at the beginning of the year and does not account for the costs of trading in and out of positions which is the hallmark of active management.
Anyone who doubts the role of luck in active management should consider the cautionary tale of Bruce Berkowitz of the Fairholme Fund. In 2010, Morningstar named him not merely the Fund Manager of the Year but the Fund Manager of the Decade. The accolades came pouring in along with a huge wad of investor cash (about $4.4 billion). After all, how could they possibly go wrong with the guy who did not simply beat the market, but tackled it to the ground and pummeled it into submission? Unfortunately, the answer came in 2011: The Fairholme Fund suffered decimating loss of 32.4% that essentially wiped out all the investor wealth that had been created by the high returns of the prior decade (about $5.1 billion).4 Returning to the chart of individual company returns, if Mr. Berkowitz or anyone else had been assigned the task at the beginning of 2011 of picking a collection of large cap companies that would lose 32.4%, they would have had an extraordinarily difficult time indeed (the average of their picks would have to fall in the bottom 15% of stocks). This shows us that even if there is such a thing as stock picking skill, it is overwhelmed by luck.
So the next time you hear a CNBC talking head say, "It's a stock picker's market," you can be sure that you have learned nothing about the market but a great deal about the fool who said it.
3 Sharpe, William, "The Arithmetic of Active Management," The Financial Analysts' Journal, Vol. 47, No.1, January/February 1991. Pp. 7-9.
4 All numbers related to the Fairholme fund are sourced from Morningstar Direct ®