Dispelling Investment Myths: Stock Picking

The Myth: Investment advisors can consistently add value to your portfolio by exercising superior skill in individual stock selection.

The Truth: Regardless of how intelligent or talented a financial advisor is, his past ability to pick stocks has little or no correlation with his ability to repeat stock-picking success in the future.

Here’s a question I get all the time: “Hey David, what do you think about [insert company name]?” Usually, they are excited about a company or product they’ve just read about (or, more likely, heard about on TV), and have come to believe this certain company’s stock is a sure bet. They want me to confirm their instinct to invest. I understand the desire to get in on something early and strike it rich, but the likelihood of it working out the way they expect is miniscule. Unfortunately, the financial media preys on this desire on both the micro (individual stock) and macro (mutual fund) levels.

The most prominent investment philosophy in the financial world is based on the idea that financial markets don’t properly price individual stocks. Some investment firms convince clients they have the ability to consistently predict the future. You may have heard an advisor say something like, “This stock is the new Apple!” to entice buyers to invest in a low-priced stock that they believe will skyrocket. By buying these allegedly mispriced stocks, they suggest that you can profit from the new price when the market corrects itself.

On the surface, it seems to make sense that these advisors can really predict stock values. We see advertisements for mutual funds that earned 10% over the S&P 500 during the past 2–5 years. Financial firms with advertising power appear trustworthy because they employ some of the brightest and most financially savvy minds in the world, from MIT mathematicians to Harvard MBAs.

The truth is that most mutual funds earn less over a 5-year period than a benchmark index, such as the S&P 500. If managers were truly able to identify mispriced stocks, bonds, and other financial instruments, then the majority of mutual funds would offer better returns than a benchmark index. Yet more often than not, fund managers are unable to beat the market. Even the handful of actively managed funds that do outperform the S&P 500 index can’t demonstrate that their active management was the reason for the fund’s superior performance. The fact is that fund performance is overwhelmingly indistinguishable from luck. Of course, the fact that taking credit for fund performance is like taking credit for an eclipse doesn’t stop fund managers from touting their track record to lure investors.

To be sure, stock picking can be tempting. That’s especially so when we fall behind on our savings goals and feel pressured to make up for lost time. That situation prompts many people to seek a home-run investment. For some people, stock picking is fun – while they’re ahead. But it’s stressful to be wrong. Even if you’re right in week one or quarter one, you have to continuously do your homework or else you’re just gambling. Remember: when it comes to gambling, the house (casino) always eventually wins. The hard-learned lesson is that gut instinct and hype-based investing can crush your finances.