September 01, 2017
Mark Minchin

The Perils of Individual Stock Picking

Selecting and buying individual stocks offers both the hope of great returns (you might find the next CSL or Apple) and the potential for disastrous results (ending up with Babcock and Brown or Centro Properties Group). In this white paper, Mark looks at the odds of success investors face when attempting to pick individual stocks for their portfolios.

You might think you are good at picking stocks (and investing in general), but the bad news is that the odds suggest you’re probably not. Now there may be a few of you reading who have had great success picking stocks, and part of that is due to luck, but as a collective we’re pretty hopeless.

DALBAR releases a yearly study called ‘The Quantitative Analysis of Investor Behaviour’. They have found that the average equities investor underperforms the market by 4.3% p.a. (the long term return of the market is around 9%).

So why do most people think they’re good at stock picking and investing generally? Likely the same reason people think they are better than average drivers! It is a built-in evolutionary, behavioural bias that’s part of how we’ve been wired. This overconfidence serves us well in many aspects of our lives, but can be quite destructive when we’re investing.

For most of us, the most important ingredient for successful investing is understanding our own behavioural flaws. Stock picking is actually a profoundly difficult occupation that shouldn’t be attempted by all but the most seasoned professionals. Let me try and explain why…

A few years ago Longboard Asset Management completed a study called ‘The Capitalism Distribution’ that examined stock returns from the top 3000 stocks in the US market (the Russell 3000 Index) from 1983 through 2007. They found that over the period:

  • The index delivered an annualised return of 12.8% and a total return of 1,694%.
  • The average (mean) stock return was -1.1% p.a.
  • 39% of stocks lost money.
  • 19% of stocks lost more than 75% of their value.
  • 64% of stocks underperformed the market.
  • 25% of stocks were responsible for all of the market’s gains.
  • 6.1% of the stocks outperformed the market by more than 500%.
  • Data from this study implies that by simply picking a stock at random, you have a 64% chance of underperforming the market index, and roughly a 40% chance of losing money.
  • Some of you may be finding this all a bit confronting and you may be wondering how the Russell 3000 Index can have an overall positive rate of return (12.8% p.a.) when the average annualised return for all stocks is negative (-1.1%).

The answer to this question is important, and if you take one learning from this paper, make it be this: The reason is that stock returns are not normally distributed – the dispersion of individual stock returns does not resemble a bell curve where the median return is the same as the mean return. If the dispersion of individual stock returns resembled the bell curve, the returns of half the stocks would be above the mean, and half would fall below the mean.

As you have seen, this isn’t the case. The reason is that your upside on a stock is unlimited (ie you could achieve a return of 1,000% or more if you hit jackpot), but you can only lose 100% of your investment on the downside. As a result, there are far more stocks that have below “average” returns, than there are stocks with above “average” returns.

A further study by Hendrik Bessembinder considered US stocks versus US Treasury Bills over the period 1926 through 2015. He found that less than a half of stocks actually beat the returns of one month Treasury Bills. This implies that you are statistically likely to get a superior return from cash, than from single stock strategies!

In contrast to Bessembinder’s single stock findings, research shows that in Australia the stock market index beats the bank bill index around 88% of the time over rolling ten year periods. So investing in stocks in a diversified way, with a long term time horizon, provides you with pretty good odds of success.

Despite this compelling evidence, Australian investors have typically invested in an undiversified way. Moreover, they have leaned toward hand picking just a small number of stocks. So this raises the question: why don’t more investors diversify broadly? Following is a brief list of some of the possible reasons why:

  • Most investors are not schooled in finance and modern portfolio theory, so they don’t have a clear picture of how many stocks are required to build a truly diversified portfolio.
  • Investors have a false perception that, by limiting the number of stocks they hold, they can manage their risks better.
  • Investors confuse the familiar with the safe. They believe that because they are familiar with the company, it must be a safer bet than one with which they are unfamiliar.
  • Overconfidence: Nobel Prize-winning economics professor at Yale, Robert Shiller, notes that “individual investors and money managers persist in their belief that they are endowed with more and better information than others, and that they can profit by picking stocks.”

If you have made any of these mistakes (I know I have), you should endeavour to modify your behaviour going forward. Knowledge is power, so they say.

How do Minchin Moore tackle this issue?

As most of you will know, our investment process is stewarded by our six person Investment Committee, who collectively bring well over 100 years of investment experience. Each member of the committee has been required to school themselves in the field of behavioural finance. With this knowledge we have worked hard to develop a culture of “calling out” behavioural biases as they arise (and they regularly do).

Perhaps most importantly, our investment charter requires that we take an “evidenced based” approach to portfolio construction. Or put another way, we place little value on “hunches” or “good stories”, preferring to take a much more scientific approach. If an investment or idea doesn’t stand up when scrutinised in a scientific way, it is dispensed with.

As we have seen, there is unnecessary and unjustifiable risks associated with holding concentrated portfolios of stocks, so we diversify broadly, both across and within asset class sectors. By way of example, a typical portfolio would hold the following:

  • Australian Equities: circa 200 stocks
  • Global Equities: circa 5,800 stocks
  • Australian Credit & Bonds: circa 300 securities
  • Global Credit & Bonds: circa 4,500 securities
  • Real Estate Investment Trusts: circa 400 securities
  • Single Stock Picking: the Bottom Line

Many of you will be saying: “I understand all of this, but I get a real kick out of picking stocks”. It may give you a thrill, much like picking a horse at the races.

If this is the case, that’s OK. But just be aware of the risks you are taking. Individual stock picking is an endeavour more closely resembles “buying a lotto ticket”, than considered long term investing.

If you can afford to lose some money and you get a thrill and enjoyment from stock picking – then continue to do so. You don’t need to feel bad about it. Just be sure to quarantine your stock picking activities in the “entertainment bucket” and don’t confuse the money you allocate there to the money you allocate to the “prudent investing bucket”.

It is also critical that you size your “entertainment bucket” in a manner that is appropriate for you, your needs and your level of resources. Your adviser can help you with this.

The Importance of Independence in Advice

The fundamental structure of the advice industry in Australia has been flawed, pretty much since its inception. The dishonest advice practices that are being uncovered daily by the Royal Commission are entirely the product of a deeply flawed industry structure.  Over half of financial planners today are employed or licensed [Read More]

April 22, 2018