Many equity investors are not satisfied with the average return on the market. With the targeted selection of individual stocks, they try to achieve higher profits. This is called stock picking in technical jargon. But with this approach, what are the chances of being successful?
It is living proof that it is possible to outperform the market average over the long term by investing in a small number of carefully selected stocks . Hardly any other investor has mastered stock picking as well as he does. Investors love such success stories. They make them feel good that they can do it.
Stock picking is a fine art
But on the stock exchange it is no different than in top-class sport. Poor performance of most professional equity fund managers who fail to outperform the market average. Picking the raisins out of the cake is obviously a fine art that few have mastered. Many investors are not frightened by such irrefutable facts. The temptation to discover the future super stocks, the new Apples, Amazons and Googles of this world early on and to get rich with these stocks is simply too great. But – aside from personal talent – what are the mathematical odds that a private investor can excel in stock picking in the long term? If you follow the data, the outlook is pretty bleak.
Stock picking is a global competition in which there are many losers
The starting point: The shares of all listed companies around the globe together make up the world stock market. A passive market fund is a portfolio that is weighted according to the market value of the individual firms and includes securities from each firm. Its return represents the market average. To beat the market, investors need to build an “active” portfolio that differs from the market portfolio. The weighted return of all active portfolios corresponds exactly to the market return. In stock picking, there can only be a limited number of winners whose above-average returns result from the mistakes of the losers. In other words, if some investors cut a larger piece of the pie, the other investors’ pieces will be smaller.
Stock picking is a competition in which you as an amateur compete against the world’s elite of professional investors. Against the accumulated expertise of the fund industry, against the masterminds of Wall Street banks and against the geniuses among the hedge fund managers. They all hunt for tomorrow’s winners around the clock – powered by the best analysis and trading software money can buy.
Private investors lack time, resources and know-how
In the other side, you sit at your PC at home, stare at unenlightening business price tables, cling to the mouths of publicity clowns who say they know how things are and ingest company statistics from third and fourth hands that you don’t even know if they even matter. You can’t build your own in-depth review. You may not have the time, access and in all probability, the know-how for accurate business results.
The alternative to tricky stock picking: Buy the whole market
Investors who don’t have what it takes for stock picking are better advised to bet on the whole market with exchange-traded index funds (ETF). Then they have the many losers in their portfolio, but also all the super stocks. In the long run, the world stock market was delivering a decent return of around 7 percent a year.