Stock picking is simply the activity of choosing shares or bonds in which to invest. The really hard bit is knowing which ones to pick. But that doesn’t put individuals – in fact a whole investment industry – off trying.
Investors decide which companies they will back by buying their shares based on a number of reasons. Maybe they have been a lifelong customer and always received good service. Or they see lots of their friends and family buying the company’s products so think it must be successful.
With a bit of research you may even go so far as to pick a company based on a trend, like backing a wind farm because of the rise of eco-activism.
Unfortunately, as compelling as these reasons or stories sound, they rarely make good investment sense. Picking the “next big thing” out of a sea of tens of thousands of companies is extremely hard and knowing when to sell it to make a profit is just as difficult.
Selling Fast and Buying Slow, a study published in January 2019, looked at 2 million sells and 2.4 million buys made by professional institutional portfolio managers – the kind who run your pension fund – between 2000 and 2016. Investors showed some skill in buying; the stocks they bought tended to outperform the stocks they didn’t. But they showed very little skill in selling.
Stocks these professional fund managers sold outperformed the ones they held onto. In fact, the researchers found, they would have produced significantly higher returns if they had simply sold stocks at random.
Take fund manager Neil Woodford, darling of the investment world for more than a decade and lauded as a “star manager”. His flagship fund, Woodford Equity Income, once worth more than £10bn is now worth only £2bn, after its share price plummeted in the wake of a series of disastrous stock picking decisions to back untested companies that turned out not to be as successful as he had thought.
Thousands of investors have lost up to two thirds of their money in the fund, many who invested their pensions, and can’t access the rest until at least 2020. Woodford Investment Management has been forced to wind up.
Woodford has been accused of relying on ego over data. Research by investment and banking giant JP Morgan shows how easily this is done.
JP Morgan looked at the returns of individual stocks within the Russell 3000 Index – the 3,000 largest US companies – between 1980 and 2014 – and compared them to the return of the index as a whole.
If found two-thirds of all shares returned less to investors than if they had just followed the index. Four out of 10 shares recorded an absolute loss. The same amount had a ‘catastrophic crash’, which means their share price fell by more than 70 per cent and failed to fully make that back.
Overall, the average stock returned investors -54% compared to just investing in a cheap index fund that tracks the whole index.
As well as being more likely to lose money, stock picking investors typically have to pay higher fees for stock brokers or other money managers to buy and sell shares.
Robin Powell, editor of The Evidence-Based Investor, says: “In aggregate, after costs, active investors will end up with lower returns than investors who simply buy and hold the whole market using low-cost index funds. It’s simple arithmetic.”