It’s not difficult to understand why so many people are drawn to the idea of investing in individual stocks in hopes of “beating the market.” Picking stocks plays into several cognitive biases that humans suffer from, including overconfidence. Overconfidence bias is when people overestimate the probability of a good outcome and underestimate the probability of a bad outcome.
As I will demonstrate with data, anyone who picks stocks has an overconfidence bias. They are downplaying the very real possibility of a bad outcome.
You don’t have to look far to find stories of people who became rich by picking stocks. People who promote picking stocks are pushing a compelling story typically; it’s some variation of “If you listen to me, you too can become rich picking stocks.” However, if you look at the data and academic research, it’s clear that the story that stock pickers are pushing is simply that; a story.
The reality of picking stocks
Investing in the stock market is inherently riskier than investing in a safe asset such as short-term government bonds. Investors accept this increased risk because they are compensated with a higher expected return. The difference between the expected return of the stock market and risk-free assets is referred to as the risk premium for stocks.
If the stock market did not have a risk premium, there would be no incentive to invest in the stock market. Why take on more risk if you are not expecting higher returns? It’s important to understand there are two types of risk investors take on.
- The risk that the entire stock market could drop is a Systemic Risk. Investors cannot diversify that risk away, but they are compensated with a risk premium.
- The risk that an individual company or industry could collapse is called the idiosyncratic risk. Investing in individual stocks presents an additional risk that investors are not compensated for.
Translation; picking stocks introduces additional risk without increasing your expected return. There is no rational basis for investing this way.
Much like the stock pickers, I just spun you a simple story about investing. Unlike the stock pickers, I will back up this story with academic research and data.
The Efficient Market Theory
As I’ve written in the past, if we accept that the stock market is efficient, it’s reasonable to conclude that the most rational investment decision would be to invest in the entire stock market through low-cost index funds.
In a 1965 paper, the University of Chicago Economics Professor Eugene Fama concluded that stock market prices move randomly and that the price of stocks is representative of all known information.
Put simply, Eugene Fama’s research suggests that the stock market is reasonably efficient. In 2013, Fama won the Nobel Prize in Economics due to his research in this area.
Fama’s research would suggest that it’s impossible for stock pickers to consistently beat the market. Stock pickers that do beat the market likely have done so due to luck rather than their brilliance and intuition.
This is a perfect opportunity to remind everyone of a simple truth about decision-making; a bad decision (like picking stocks) can lead to a good outcome. That does not mean it was a good decision.
Facts that stock pickers don’t tell you
“By picking individual stocks you have a higher probability of underperforming a risk-free asset than you do of beating the market.”
If you currently own individual stocks, I urge you to read the 2018 paper by Hendrik Bessembinder from Arizona State University entitled “Do Stocks Outperform Treasury Bills?”. Here is a summary of the paper.
- Bessembinder studied the lifetime performance of individual stocks in the U.S dating back to 1926.
- 60% of all stocks that he studied had a lifetime return less than a 30-day U.S Treasury Bill (T-Bills).
- That means that you would have had better returns if you had invested in T-Bills (which are risk-free) than if you had invested in the majority of U.S stocks since 1926.
- 4% of U.S stocks accounted for 100% of the gains in the U.S stock market since 1926.
- Bessembinder concluded that “The results help to explain why poorly-diversified active strategies most often underperform market averages.”
The results of this research make it clear that picking stocks is a losing game. By picking individual stocks, you have a higher probability of underperforming a risk-free asset than you do of beating the market.
Stock pickers would tell you that all you need to do is find the 4% of stocks that drive the market, and you’ll be rich. The problem is that there is no way of knowing which stocks will drive the market beforehand. It’s only in hindsight do we know which stocks moved the market.
As legendary index investor Jack Bogle put it, “Don’t look for the needle in the haystack. Just buy the haystack”. Translation: Don’t Invest in individual stocks. Invest in the entire market.
What’s the worst that could happen?
The worst-case scenario for stock pickers is that the stock they pick goes to zero. While this is rare, it is not unheard of. Famous examples include Lehman Brothers and Enron.
While it is rare that you would lose “all” of your money picking stocks, you will likely lose “most” of your money.
A 2014 study conducted by J.P. Morgan looked at all publicly traded stocks in the U.S dating back to 1980. 40% of the 13,000 stocks in the study declined by more than 70% from their peak value and never recovered.
When it comes to picking stocks, the most likely scenario is that you lose. That is a game I would rather not play.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions
