Picking Market-Beating Stocks

The vast majority of investors would collect higher returns if they simply avoided buying individual company stocks and stuck with investment funds that track the market.

Personally, I only buy individual company stocks sparingly and would likely be better off, as with most investors, by practicing what I preach and avoiding individual company stocks altogether. Every now and again, though, I get a wild hair and think I can pick stocks successfully.

Most of my stock picks have turned out fine, increasing in value over time. So, I’m not saying investors can’t make money buying individual company stocks.

My contention is that investors’ portfolios would perform even better if they didn’t.

It is deceptively difficult to outperform an investment that just tracks the performance of the overall stock market, owning the entire market rather than only a few companies that you think are poised for impressive growth.

What makes picking stocks so difficult? Let’s find out.

For our purposes, we are going to focus on attempting to outperform the S&P 500, which is the most common benchmark for the U.S. stock market.

In a recent missive to investors, researcher Anu Ganti provided data that helps frame the daunting task faced by stock pickers. Ganti looked at performance of all 500 companies in the S&P 500 over the past 25 years. She stacked them from the best performing to the worst. Then, Ganti calculated two simple averages: (1) the median, and (2) the arithmetic mean.

You may recall from 5^th or 6^th grade math class that the median is simply the return of the middle value of an ordered data set. So, in this case, Ganti looked at the cumulative returns of the 250^th and 251^st best-performing funds in the S&P 500. That percentage was 59%.

Next, she calculated the arithmetic mean, which is just the average of the cumulative returns for all 500 companies in the S&P 500. That percentage was 452%.

The arithmetic mean, in other words, was substantially higher than the median.

What does that tell us in plain English?

It means a small number of companies in the S&P 500 significantly outperformed the others and this skewed the average return higher. If you didn’t own those high-flying companies, it would have been darn near impossible to outperform the market. The problem is there’s no easy way to preemptively pick those high-flyers. And if you don’t, the odds are massively stacked against you outperforming the market.

So unless you possess the rare ability to handpick companies that will ultimately become rocket-ship performers – tremendously easy with hindsight, terribly difficult with foresight – then you are destined to underperform the market if you pick individual companies.

I wish I could fully express how monumental the challenge is to pick market-beating stocks. Some people say, “All it takes is one.” And that’s true. But identifying the one is an immense challenge in and of itself. The task gets even taller if you begin picking more than one stock. Spreading your bets doesn’t make the job easier. It makes it harder.

To prove how difficult it is, look no further than the SPIVA Scorecard, a long-running analysis of professional investment managers. The scorecard tracks how many investment managers outperform the overall market. In the latest reading, 86% of the managers underperformed the market over the last 10 years and 88% over the last 15 years.

Keep in mind, these are incredibly bright and motivated individuals, who spend most of their waking moments thinking about investments. They have teams of analysts and millions of dollars in research available to them.

And 88% of them still can’t outperform the market.

Ask yourself a simple question: What does that mean for your chances?