Take a passive approach: because stock picking is a matter of luck

At True Wealth, we pursue a passive investment approach for our clients. To many, this sounds strange at first: Passive? Don't they do anything? Far from it. We take great care to ensure that our investors receive the best possible portfolio. One that suits their personal risk capacity and risk appetite. But there is one thing – and this is the passive aspect of our approach – that we deliberately refrain from doing: we do not invest any energy in selecting individual stocks. This is not necessary in passive or index-based investing.

There are three good reasons for this:

Most people choose the wrong stocks

Many try to pick the right stocks and buy and sell them at the right time. This usually goes wrong: most investors lose money in the long term with this strategy. This has been demonstrated by numerous studies and has been the consensus in financial research for decades. The regularly updated fund evaluations by SPIVA, the research department of S&P Global, are extremely illustrative. The data is publicly available and the results can be broken down by region and time period.

The data shows that

• after just one year, most funds underperform.
• The underperformance increases further over time.
• The same pattern can be seen in all regions of the world.

Nevertheless, Swiss fund managers are still slightly better off than their European and American counterparts after ten years: ‘only’ 78 per cent of them underperform.

True Wealth has also conducted its own analysis of the most popular Swiss investment funds using SPI as a benchmark and determined their long-term performance. The results are fairly consistent. We would like to refer you to our video on this topic (in Swiss German with English subtitles).

Professionals can hardly do better than amateurs

Private investors sell the wrong stocks and buy the wrong stocks. This may be partly because they are easily influenced by the news. By all the information that comes flying at them every day in a disorderly fashion.

Professionals are more selective in this respect. They also process a lot of information. However, they react less impulsively to what they hear ad hoc and instead search for information in a targeted manner. They are also generally well educated and some of them have years of experience. This helps them to put the information into a meaningful context. And – because they are paid to do so – they also have the time to search for information that has not yet made it into the headlines.

That is why they like to call themselves ‘smart money’. One would think that with this background, they would be able to solve the problem of skimming off the extra returns that private investors have missed out on for themselves and their clients.

However, the results of over fifty years of research paint a very different picture.

As John C. Bogle, who died in 2019, summarised, typically two out of three investment funds underperform the benchmark they are trying to beat every year. So do you have to find the one manager who has beaten the market and two of his colleagues?

Fund managers are just lucky

Daniel Kahneman once had the opportunity to look at the world of professionals from the inside. The psychologist, who won the Nobel Prize in Economics in 2002, was able to work with the internal data of an asset manager on Wall Street. The company meticulously recorded the performance of its managers. After all, it is the performance of the assets under management that ultimately determines how high each manager's bonus will be at the end of the year.

What interested Kahneman most about this internal data was whether the portfolio managers who performed well this year would also be the best next year. Is good performance consistent? To answer this question, he examined the results from eight years and compared each year in pairs: year one with year two, year one with year three, and so on, up to year seven with year eight. This resulted in 28 correlation coefficients, exactly one for each pair of years in comparison.

Kahneman only started this calculation because he suspected that performance would not be particularly consistent, that consistency would be weak overall, and that ultimately the annual performance of each manager would also depend on luck. Nevertheless, he had assumed that performance would also depend to some extent on skill. Just like in a game of poker. Although the cards are a matter of luck, good players bet more when they have good hands and less when they have bad cards.

The result surprised even the sceptical Kahneman: it was even weaker than expected. The average correlation was 0.01 – professional stock selection was no better than a game of dice. (In that case, the correlation between the throws would be 0.00 – if you throw long enough.)

Do you want to pay professionals for your luck?

We are used to paying for performance. We are even happy to pay for good performance. But do we really want to pay for luck? That is why our stance at True Wealth is clear: we save you the cost of stock selection. And we put together your portfolio from low-cost exchange-traded funds (ETFs) that do not engage in such selection.

Links

• S&P Global: SPIVA Scorecard results for markets around the world.
• Terrance Odean: Do Investors Trade Too Much?
• Brad M. Barber and Terrance Odean: Trading Is Hazardous to Your Wealth – The Common Stock Investment Performance of Individual Investors
• John C. Bogle: Common Sense on Mutual Funds – New Imperatives for the Intelligent Investor (New York: Wiley, 2000)
• Daniel Kahneman: Thinking, Fast and Slow. (New York: Farrar, Straus and Giroux, 2011)

An earlier version of this article was published on 8 January 2016.