The financial media encourages you to buy individual stocks that a self-professed “guru” believes are underpriced. These entreaties appeal to the understandable desire of investors to make “a killing” by uncovering the next Facebook or Microsoft. The real reason for the stock picking focus by the media and the securities industry is more insidious. Buying and selling stocks generates revenues. More revenues means more profit for them, and lower expected returns for you.
The folly of stock picking
The perils of stock picking are well documented. As one commentator accurately noted: “But because investors are not rewarded by the markets with higher expected returns for taking uncompensated risk—risk that is easily diversified away—the rational strategy is not to buy individual stocks.”
The odds of picking an individual stock that will outperform the index to which it belongs is small (around one-in-three).
Those who tell you they have the ability to pick outperforming stocks have rarely demonstrated the ability to do so. One comprehensive study looked at the performance of 2076 actively managed mutual funds (where the fund managers engage in stock picking in an effort to “beat the market”) from 1975-2006. The study found 99.4 percent of these fund managers demonstrated no evidence of stock picking ability. The balance of 0.6% were lucky, with no evidence of skill either.
One of the co-authors of the study stated he had “generally been positive about the existence of fund manager ability,” but found this data to be a “real shocker.”
Dismal performance of hedge funds
What about hedge funds? Certainly those super managers who charge obscene fees to wealthy clients must have the ability to pick outperforming stocks, right?
According to an article in Bloomberg, more hedge funds closed in 2016 than at any time since the 2008 crisis. The article noted, “The average fund hasn’t beat the S&P 500 Total Return Index, a measure that includes reinvested dividends, since 2008.”
It’s not surprising that investors pulled over $70 billion from these funds in 2016. Why anyone invests in them is a mystery.
A real bargain
Trying to find a mispriced stock is like looking for a blue sweater in your size that’s on sale at your favorite department store. But there’s good news your broker doesn’t want you to know. Because of a price war among major fund families, all stocks are on sale and can be purchased at a bargain price. There’s no need to hunt for the sweater you want. Every item in the department store is yours for a fraction of its prior cost.
You can own Vanguard’s Total World Stock ETF (VT), which gives you a share of the domestic and foreign stock markets, for an expense ratio of only 0.11 percent which is 91% lower than the average expense ratio of funds with similar holdings, according to Vanguard. This fund holds 7651 stocks, with a median market cap of $36.9 billion.
For the five year period ending February 28, 2017, VT had average annual returns of 8.77 percent. Since inception on June 24, 2008, it returned 5.22 percent.
Not to be outdone, Schwab recently announced reductions in the expense ratios of its S&P 500 Index Fund (SWPPX) and its Small-Cap Index Fund (SWSSX) which it lowered to 0.03% and 0.06%, respectively. Its U.S. Aggregate Bond ETF (SCHZ) has an expense ratio of only 0.05 percent.
The cost of owning a globally diversified portfolio of stocks, and a portfolio of bonds that track the Barclays U.S. Aggregate Bond Index is now minuscule. It’s less than half the cost of the fee for a low cost robo-advisor, although robo-advisors offer other services that may make it prudent to consider them.
There’s a clear link between fees and performance. Morningstar found funds with high fees have below average performance and those with high fees have “a higher likelihood of above average performance”, although that’s not a guarantee.
Instead of succumbing to the snake oil pitch of TV pundits pretending to have a stock picking expertise that doesn’t exist, take advantage of the low prices for owning the entire stock and bond markets. There’s never been a better time to do so.
The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.
Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.
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