Year after year, it is getting harder and harder for mutual funds to outperform the index. Even if the top stock pickers get high scores in one year, they always seem to be mediocre in the second year. Of course, the costs associated with the management of mutual funds are high; at the same time, some of the largest mutual funds have been underperforming the market.
Therefore, you may question whether mutual fund managers can really pick stocks. If mutual fund managers can successfully select stocks, then people will think that the actively managed prices of mutual funds are worthwhile. But if the opposite is true, are index funds really the best choice for investors?
Pick stocks in an efficient market
For anyone who has taken a basic finance course at the college or university level, you may remember the Efficient Market Hypothesis (EMH). The EMH theory originated from Eugene Fama of the University of Chicago; in the early 1960s, Fama made his thesis that financial markets are-or can be-very efficient.
- The costs associated with the management of mutual funds are high; at the same time, some of the largest mutual funds have been underperforming the market.
- Therefore, you may question whether mutual fund managers can really pick stocks.
- The Efficient Market Hypothesis (EMH) questions the feasibility of continuously outperforming the market by using information that may not be fully reflected in the price of a security.
- Although it is important to study efficiency theories—and to review empirical studies that provide credibility—in reality, the market is full of inefficiencies.
- Most contemporary stock pickers are in trouble; although they believe that most investors have the same access to information, the interpretation and implementation of these data is where stock pickers can add some value.
This concept implies that market participants are mature, informed, and act only on the basis of available information. Since everyone has the same access to this information, all securities have the appropriate pricing at any given time.
Although the theory does not necessarily deny the concept of stock selection, it does question the feasibility of continuously outperforming the market by using information that may not be fully reflected in security prices.
For example, if a portfolio manager buys a security, they believe it is worth more than the price paid now or in the future. In order to purchase the security with limited funds, portfolio managers also need to sell securities that they believe are of lower value now or in the future; again, this involves the use of information that is not yet reflected in the stock price.
EMH is usually presented in three different forms: weak, semi-strong and strong. The weak theory means that the current price is accurately based on the historical price; the semi-strong means that the current price is an accurate reflection of the financial data available to investors; the strong form is the most robust form, meaning that all information is basically included in the security price .
If you follow the first form, you are more likely to think that technical analysis is almost useless or useless; the second form means you can abandon your basic security assessment techniques; if you subscribe to the strong form, you might as well put your money Under the mattress.
Although it is important to study efficiency theories—and to review empirical studies that provide credibility—in reality, the market is full of inefficiencies. One reason for inefficiency is that every investor has a unique investment style and way of evaluating investment. One person may use technical strategies, while others may rely on fundamentals; still others may resort to simply using dice or darts.
There are many other factors that affect investment prices, including emotional attachment, rumors, securities prices, and the relationship between supply and demand. Part of the reason for the implementation of the Sarbanes-Oxley Act of 2002 was to improve the efficiency and transparency of the market, because certain parties’ access to information was not fairly disseminated. After the implementation of the bill, it is difficult to say how effective it is. But, at least, it makes people more aware and makes certain aspects more accountable.
Although EMH does mean that there are few opportunities to use information, it does not rule out the theory that managers can defeat the market by taking some additional risks. Most contemporary stock pickers are in trouble; although they believe that most investors have the same access to information, the interpretation and implementation of these data is where stock pickers can add some value.
The stock selection process is based on the strategies analysts use to determine which stocks to buy or sell and when to buy or sell. Peter Lynch is a well-known stock picker who has adopted a successful strategy during his years of work at Fidelity. Although many people think that he is a very smart fund manager, and based on his decision to rank among the best in the industry, the stock market at the time was also good for the stock market. He may have a little luck. Although Lynch is primarily a growth manager, he has also incorporated some value skills into his strategy. This is the beauty of stock picking: no two stock pickers are the same. Although the main varieties are in the field of growth, the changes and combinations are endless. Unless they have an absolutely unchangeable strategy, their standards and models may change over time.
Is stock picking useful?
The best way to answer this question is to evaluate the performance of the portfolio managed by stock pickers. It is also helpful to start a debate between active and passive management.
Depending on the period you are focusing on, the S&P 500 index is usually higher than the median in the active management field. This means that usually at least half of active managers fail to outperform the market. If you just stop there, it is easy to conclude that managers cannot effectively pick stocks to make the process worthwhile. If this is the case, all investments should be placed in an index fund.
Excluding management fees, transaction costs of transactions, and the need to hold cash weights for daily operations, it is easy to see how the performance of the average manager lags behind the average index due to these constraints. The odds are just against them. After removing all other costs, the game is closer.
In hindsight, it is easy to recommend investing only in index funds, but the attractiveness of these high-flying funds is difficult to resist for most investors. Quarter after quarter, funds flow from underperforming funds to the hottest fund in the first quarter, just to chase the next hottest fund.
The success of stock picking has always been a hot topic, depending on who you ask, you will get a variety of opinions. There is a lot of academic research and empirical evidence that shows that over time, it is difficult to successfully select stocks that outperform the market.
There is also evidence that passive investments by index funds can defeat most (more than half) active managers in a matter of years. The problem with proving the ability to pick stocks successfully is that individual stock picking becomes an integral part of the total return of any mutual fund. In addition to the manager’s best choice, in order to fully invest, stock pickers will undoubtedly end up choosing stocks that they may not have chosen in order to maintain popular trends. In most cases, it is human nature to believe that there are at least some inefficiencies in the market; every year, some managers successfully pick stocks and outperform the market. However, as time goes by, few of them insist on doing so.