Stock Picking does not Work

binoculars2

Individuals are often misguided by the financial media, which suggests that by listening to enough programs about money, you can buy stocks that will make you rich. These programs focus on quick, high returns, not accounting for investment risks over the course of an investor’s life or his or her personal situation.

Traditional Investment Advisors attempt to outperform the market by predicting which future securities will perform the best or by taking advantage of market mispricing.

However, claims that investors or professional managers can predetermine the few stocks that account for much of the market’s return each year are unfounded. Missed opportunities arise when people spend time trying to select these stocks. We believe that investors truly succeed when they stay fully invested as well as broadly diversified to capture the market’s entire potential for return.

Graphic 4: It is almost impossible to choose the stocks that outperform

chart4

Source: Dimensional Fund Advisors. Results based on the CRSP 1-10 Index. CRSP data provided by the Center for Research in Security Prices, University of Chicago. Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Information contained herein is compiled from sources believed to be reliable and current, but accuracy should be placed in the context of underlying assumptions. Past performance is not a guarantee of future results.

As Graphic 4 illustrates, much of the market’s return each year is a result of the strong performance by select stocks. Managers cannot identify these stocks in advance. By broadly diversifying as well as fully investing, investors can capture the returns of any large market.

VERY FEW EQUITY FUNDS BEAT THEIR CATEGORY BENCHMARK CONSISTENTLY

According to The Center for Research in Security Prices (CRSP), the most comprehensive database of stock and mutual fund data, roughly half of equity mutual funds survived for the 10 years ending in 2013.3 Those with poor track records were often closed. As you see in Graphic 5 below, very few active managers actually beat their chosen equity benchmark and achieve returns greater than those of the market. Furthermore, research by Economic Nobel Prize Winner Eugene Fama and his colleague Kenneth French indicates that even fund managers who have outperformed the market for 10 years are unlikely to win again over the next 10 years.4

As Graphic 5 shows, only 19% of fund managers beat their performance benchmark over 10 years. However, many need their investments to work for them for 40 years or more.

Graphic 5: 19% of equity managers beat their benchmarks over 10 years

chart5

Source: Dimensional Fund Advisors. Using CRSP data provided by the Center for Research on Security Prices, University of Chicago. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Information contained herein is compiled from sources believed to be reliable and current, but accuracy should be placed in the context of underlying assumptions.

The record for active fund managers is lackluster, and their advice is expensive in two ways:

  • The high expense ratio of the fund fees paid to the mutual fund manager versus the fund’s dollar value.
  • Transaction costs, i.e., the cost of buying and selling stocks within a fund, are not included in the expense ratio and are additional to it.

There is a cost for every buy or sell order a manager sends to market. These transaction costs (an average of 1.44% per year in expense) are not reported, adding to the stated expense ratio.5 John Bogle, founder and former CEO of the Vanguard Group, suggests that you multiply the turnover of a mutual find by 1.2% to calculate the hidden transaction costs.6

Graphic 6 shows that the reported expense ratio for average actively-managed funds is 1.35%. Accounting for the hidden expenses raises fund expenses to 2.43%. Passively-managed funds have much lower expenses because of their lower fund management fees and lower turnover. Our group uses the Dimensional Funds’ investment strategy, which has trading protocols and value-added trading techniques to provide some of the lowest overall expenses in the industry.

The most efficient portfolio is the entire marketplace of assets.

Graphic 6: Actively managed mutual funds have higher expenses

Chart6(a)

Expenses for the Equity Allocation exclude separate management fee.

Data as of December 31, 2013. Active Equity Funds is all active domestic mutual funds as provided by the CRSP Survivor-Bias-Free Mutual Fund Database. Dimensional Equity Funds is an average of the following Dimensional Fund Advisors mutual funds: DFQTX, DFUSX, DFSCX, DFIEX, DFALX, DISVX, DFCEX, DFREX, DFITX.

CAPITAL ASSET PRICING MODEL (CAPM)

William Sharpe, winner of the 1990 Nobel Prize in Economics, introduced the Capital Asset Pricing Model (CAPM) in 1964.

Simplifying his words, Sharpe offers three messages:

list2

 

  • CRSP data cited by Real Clear Markets: http://www.realclearmarkets.com/blog/sept12ac.pdf.
  • Eugene F. Fama and Kenneth R. French, “Luck versus Skill in the Cross Section of Mutual Fund Returns,” December 19, 2009.
  • Roger M. Edelen, Richard B. Evans, Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Trading Costs,” March 17, 2007.
  • John C. Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor (New York: Irwin Professional 1994).