Is Stock Picking a Myth?

Year after year, the return on mutual funds competes with the index. Top stock pickers may hit high marks one year, but those returns wane the following year. There are high fees associated with mutual fund management yet a mutual fund may consistently underperform the market.

When mutual fund managers successfully pick stocks, the cost of active management for mutual funds is worth it. But when the opposite occurs, are index funds the best bet for investors?

Picking Stocks in an Efficient Market

A basic finance course at the college or university level introduces the efficient market hypothesis (EMH). The EMH theory originated with Eugene Fama at the University of Chicago in the early 1960s and argues that the financial markets are, or can be, very efficient.

The theory implies that market participants are sophisticated, informed, and act only on available information, hence, all securities are appropriately priced at any given time.

While this theory does not necessarily negate the concept of stock picking, it does call into question the viability of the consistent ability of stock pickers to outperform the market.

The EMH is generally presented in three distinct forms: weak, semi-strong, and strong. The weak theory implies that current prices are based accurately on historical prices; the semi-strong implies that current prices are an accurate reflection of all historical and publicly available information; and the strong form is the most extreme, implying that all historical, public and private information is included in the price of a security.

If you follow the first form, you believe that technical analysis is of little or no use. The second form implies that fundamental security evaluation techniques are unnecessary. The strong form invests in market indices through long-term passive strategies and lets the market play out.

Markets in Reality

While it is important to study the theories of efficiency and review the empirical studies that lend credibility, markets are full of inefficiencies. Inefficiencies exist because every investor has a unique investment style and way of evaluating an investment. One may use technical strategies, while others may rely on fundamentals, and others may simply use the roll of a dice or a dartboard.

Many other factors influence the price of investments, from emotional attachment, rumors, the price of a security, and supply and demand. Part of the reason the Sarbanes-Oxley Act of 2002 was implemented was to increase the efficiency and transparency of the markets so information can be fairly disseminated.

While EMH does imply that there are few opportunities to exploit information, it does not exclude the theory that managers can beat the market by taking some extra risk. Although most investors have the same access to market information, stock pickers can provide interpretation and implementation of market data.

Stock Pickers

The process of stock picking is based on the strategy an analyst uses to determine what stocks to buy or sell, and when to buy or sell. While working at Fidelity, Peter Lynch was a famed stock picker who employed a successful strategy. While many believe he was a very smart fund manager and topped his peers based on his decisions, the times were also good for stock markets; he may have had a little luck on his side.

Lynch was primarily a growth-style manager, he also used some value techniques in his strategy, proving that no two stock pickers are alike. The variations and combinations are endless and their criteria and models can change over time.

Does Stock Picking Work?

The best way to answer this question is to evaluate how portfolios managed by stock pickers have performed. It's also helpful to open the debate on active vs. passive management.

The S&P 500 typically ranks above the median in the actively-managed portfolio, concluding that at least half of the active managers fail to beat the market. It's easy to assume that managers cannot pick stocks effectively enough to make the process worthwhile and all investments should be placed inside an index fund.

With management fees, the transaction costs to trade, and the need to hold cash for day-to-day operations, it's easy to see how the average manager underperformed the general index because of those restrictions. When all costs are removed, however, the race is much closer.

The Bottom Line

The success of stock picking has always been hotly debated and depending on whom you ask, you will get various opinions. Academic studies and empirical evidence suggest that it is difficult to successfully pick stocks to outperform the markets over time.

There is also evidence to suggest that passive investing in index funds can beat the majority of active managers. The problem with proving successful stock-picking abilities is that individual picks become components of total return in any mutual fund. In addition to a manager's best picks, to be fully invested, the stock pickers will undoubtedly end up with stocks that they may not have picked to stay in the popular trends.

It is human nature to believe that there are at least some inefficiencies in the markets. Every year, some managers successfully pick stocks and beat the markets, but consistent success over time is the true test.