The Black Art of Stock Picking

BY: ANDREW J. WILLMS

PRESIDENT AND CEO, THE MILWAUKEE COMPANY

The evidence is overwhelming: Stock pickers have a tough time beating comparable index funds through time.

One study found that from 1926 to 2016, a majority of publicly traded common stocks generated returns (inclusive of reinvested dividends) that trailed one-month Treasury bills.[1]
According to Morningstar[2], U.S. stock-pickers’ one-year success rate was 41% in 2021, while 55% of the actively managed funds underperformed their comparable passive alternatives. Morningstar also found that just 26% of all actively managed funds topped the average of their passive rivals over the 10-year period ended December 2021.
Perhaps most damning of all, active fund managers who do manage to outperform their benchmark in a given year are not likely to repeat the feat consistently. For example, only 2.2% of the 2019 top U.S. equity funds remained in the top quartile by 2021, according to analysis from S&P Dow Jones Indices.[3]

Given the foregoing, why do so many investors like to invest in individual stocks? There are several reasons, as I see it. For one, human behavior being what it is, the thrill associated with picking a winner can carry more weight with our psyche than the displeasure associated with being wrong.

For another, some people buy shares of companies for whose products or services they have an affinity, or because they favor the company’s stand on social issues or the environment.

Some investors enjoy investigating individual companies in an effort to separate the wheat from the chaff. For them, the pleasure they derive from market research is its own reward.

Lastly, many market participants seem to mistakenly believe that knowledge and skill alone are sufficient for successful stock selection, whereas in reality success or failure often depend to at least some degree, on luck.

All that being said, there is no denying that individual stocks create the potential for greater returns than do index funds; just as successfully betting on a single number on the roulette wheel will generate a much bigger payoff than a bet on red or black - if you are lucky enough to win. (Of course, this is no free lunch since it’s always accompanied by the potential for much bigger losses too.)

For all these reasons, I expect the popularity of stock-picking will endure. If you choose to speculate in individual stocks, it’s critical to limit the role that bad luck could play. Here are some suggestions on how to do so.

Limit the dollars that you invest in individual stocks to that amount you can afford to lose without negatively impacting your standard of living or your estate plan.
Establish a separate account for your stock picks, and resist the temptation to add to that account in hopes of recovering your losses if things don’t work out as expected.
Use a rules-based approach to select the stocks in which you invest, and make sure and confirm that both historical and computer-generated simulated data were used to evaluate the approach’s results. Your stock picking plan should also be stress-tested by evaluating its results over a variety of time frames and market conditions.
It’s also critical to confirm the test results were not biased by “data-mining”[4]. One way to do that is to randomly shuffle the data used to test the strategy.

For many investors, investing in individual stocks can be fun. But doing so intelligently is hard work. If stock picking is a game you chose to play, the preceding tips can increase your odds of success.

[1] Hendrik Bessembinder, Do Stocks Outperform Treasury Bills? Aug, 2017.

[2] The Morningstar Active/Passive Barometer, Feb. 2022.

[3] Dow Jones, SPIVA: 2021 Year-End Active vs. Passive Scorecard, March 2022.

[4] Data-mining bias refers to giving a strategy credit for positive test results that were in fact a product of chance or unforeseen events.