Why Stock Picking Doesn't Work for the Typical Investor

Why Stock Picking Doesn't Work for the Typical Investor
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Fraser Richardson

If you randomly picked a share listed and traded on a share market in a highly developed economy and held that share for 10 years, what return would you expect to achieve?

You might expect to achieve a healthy return of, say, 8-10% per annum on that randomly selected share. Let’s say 9% per annum.

Compounding that 9% p.a. return over 10 years gives you a return of just under 137% over that timeframe.

So, you might think it’s reasonable to expect that (dividends included), the typical share would more than double in value over 10 years.

That assumption would, in fact, be very wide of the mark.

If you randomly picked a share from among the top 500 companies listed on the US share market (the largest and most sophisticated share market in the world), your most likely outcome after 10 years is that you would lose money. That’s correct: your total return is most likely to be negative.

How can this be true when the US share market as a whole has returned an average of over 10% per year since 1957?[1]

This seemingly illogical outcome can be explained by looking at how returns are distributed across the shares that make up the market index.

Research shows that 55% of shares included in the main US share market index have negative returns over a ten-year period[2].

That doesn’t mean investing in share markets is a bad idea: as mentioned earlier, the S&P 500 has provided a long-term annualised return of over 10% over the last 67 years.

The answer lies in the fact that a relatively small number of shares make up for the losses of the majority.

In other words, the positive returns enjoyed by investors who take exposure to the whole market are attributable to a minority of winners.

This pattern increases with the length of the investor’s time horizon.

The charts below show that the longer the holding period, the larger the proportion of shares that return less than zero.

The charts also show that the longer the holding period, the higher the return from the best performing shares.

The charts above show the distribution of returns of S&P 500 stocks over different periods (1 month, 1 year, 5 years, 10 years) from 1926 to 2022. At first, you’ll notice that the 0% return is in the centre of the distribution over a one-month timeframe; however, that 0% starts to migrate to the left over one, five, 10, and 20 years, meaning that a return of 0% or better is less and less probable as time goes on. The maximum positive return also goes from 50% for the one-month timeframe to over 1,000% for the 10-year time frame

What lessons should we take as investors?

First, don’t follow a stock picking approach. Take broad exposure to the market as a whole.

Second, the longer you hold onto a randomly selected share, the more likely it is to become unprofitable.

Third, given that most investors have an investment horizon of well over 10 years (and typically 30 years or more), hanging your future financial wellbeing on a handful of shares seems like a very risky proposition.

Self-directed investors overestimate their ability to beat the market and think they can do so by picking the shares that will do better than the market average in the future.

You might have heard a few stories about wildly successful investments friends or acquaintances have made (those stories are often heard on golf courses). You don’t often hear about wildly unsuccessful investments.

The truth is that self-directed (non-advised) individual investors typically under perform the wider market by 4-5% per annum. Compounded over a typical investing lifetime, such losses do serious damage to your financial wellbeing.

Yet even many professional fund managers who follow a stock picking approach fail to beat the market consistently over longer timeframes. They might do so for a year or two, or even for a few years, but there’s plenty of evidence to show they can’t do it for long.

Do you back yourself to do better than them in selecting winners and discarding losers?

Buying and holding a diversified portfolio with broad exposure to various markets, sectors and asset classes is the best way to participate reliably in the upside of financial markets.


[1] https://www.officialdata.org/us/stocks/s-p-500/1957?amount=100&endYear=2023

[2] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4541122

The information contained in this article is intended to be of a general nature. It does not take into account the objectives, financial situation or needs of any particular person, and does not constitute financial advice.

 Cover photo by <a href="/photographer/pin-x-up-54147">Pin-x-up</a> on <a href="/">Freeimages.com</a>

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