March 24, 2012

Is there such a thing as a stock-picking guru who beats the market consistently?

If you mean having a knack for picking winners through hard work and careful research, then yes. I’ve seen this skill in action throughout my professional career, and I’m always impressed by it, because it’s very rare. But consistently picking stocks that outperform the market is even more rare. Most stock-picking gurus are just having a serial run of luck. Very few of them have the ability to beat the market consistently over time.

Am I just jealous of the people who possess a skill that I wish I had? I don’t think so, and here’s why. When you really think about it, stock-pickers are attempting to do something impossible. They’re trying to predict the future. What they’re telling you, in essence, is that they can know ahead of time which stocks will go up more than the market in general. But how can they know that? It goes against common sense and reason.

What stock pickers should be saying, if they’re being honest, is that they believe the stocks they’re picking are currently mis-priced by investors in the market. But in order for that to be the case, there must be something that others don’t understand about the company. This means that the picker knows more than the market, and I challenge any picker who claims to be that smart.

So I repeat my statement that consistent stock picking skill is as much a matter of luck as it is skill. That’s why all stock picking gurus eventually cool off or crash and burn. All of them. Whatever system or methodology they had been using eventually stops working. Maybe other pickers figure out what he’s been doing, and they start doing it too. Maybe he gets cocky and starts to cut corners. Or maybe he misses something big coming, like a recession or a fundamental change in business conditions.

The point is that nobody can tell ahead of time when a good stock picker is about to cool off. The best ones only get recognition after they have built a successful track record over time. By the time you hear about them, their lucky streak might be coming to an end. So I would advise you not to spend too much time chasing past performance, and instead spend that time on fundamental investing activities, like making sure that you’re well-diversified and properly balanced in your portfolio.

Consider this recent blog post by Daniel Solin, entitled “The Return of the Dreaded and Dreadful Stock Pickers.”  (http://www.dailyfinance.com/2011/03/25/the-return-of-the-dreaded-and-dreadful-stock-pickers/#aol-comments)

Market turbulence and economic uncertainty create fear and anxiety among investors. Unfortunately, many turn to advice freely dispensed by self-styled investment gurus — who claim they can predict the direction of the markets or pick outperforming stocks. Reliance on this advice can be very harmful to your financial well-being.

One form of stock market crystal ball reading is so-called “technical analysis.” This, according to its proponents, is the examination of patterns in the market to identify the current trend, and then looking for patterns that suggest whether that trend is likely to continue or change.

Sharing “a Pedestal with Alchemy”

There’s compelling evidence that technical analysis is nonsense. The view of those who study the capital markets, and publish peer-reviewed papers setting forth their conclusions, was nicely summarized by Burton Malkiel of Princeton University, in his seminal book, A Random Walk Down Wall Street. Professor Malkiel concluded that “under scientific scrutiny, chart reading must share a pedestal with alchemy.” The concept of using past data to predict future prices has been debunked by the efficient market hypothesis — which holds that markets are random and efficient. It is tomorrow’s news that moves stock prices and markets, not yesterday’s. No technical chart can predict tomorrow’s headlines.

Stock pickers fare no better, but they keep trying to convince you they have predictive power that will help you to gain outsized returns.The unstoppable Jim Cramer advises you to buy banks, industrials and metals and mining. Should you listen to him?

No Better Than Coin Flipping?

Consider this: A study of 1,446 large-cap blend mutual funds for the 10-year period ending Oct. 31, 2004, found only 35 outperformed the S&P 500 index. Do you believe any individual stock picker is better than these handsomely paid and well-credentialed mutual fund managers?

The CXO Advisory Group tracks Cramer’s picks, and those of other alleged “stock picking gurus.” The overall rating of the stock pickers was 48%. You could replicate these dismal results by coin-flipping or by tossing a dart at a list of stocks. Is this an intelligent way to invest and plan for retirement?

In May, 2009, CXO did an analysis of Cramer’s buy and sell recommendations. It concluded his recommendations are not particularly good or unusually bad. While Cramer likes to compare his performance to the S&P 500, the reality is his stock picks are often riskier than those in that index. In a bull market, you would expect higher returns from riskier asset classes.

study by Barron’s may also give investors pause before following Cramer’s latest recommendations. It found Cramer’s stock picks typically underperform the market. From May to December 2008, the market lost 30%. Investors who followed Cramer’s advice would have lost 35%.

“No Such Thing as Stock Picking Skill”

There’s something fundamentally wrong about making stock picks and knowing that some investors will rely on them, when there is no data indicating anyone has this expertise. William Bernstein, author of The Intelligent Asset Allocator and other valuable investing books, said: “It turns out for all practical purposes, there is no such thing as stock picking skill.” His views are shared by Nobel laureates Merton Miller, William Sharpe and Paul Samuelson, and backed up by hundreds of academic studies.

Yet the charade continues. The same “gurus” who recommended Lehman Brothers, Washington Mutual, Worldcom, Enron and other companies that later filed for bankruptcy continue to tout their skills as investing prognosticators, unashamed and without remorse. They have new “stocks picks” for gullible investors with short memories. They hope their purported “expertise” will convince you to read their blogs, watch their television shows or — worst of all — entrust your money to them. I don’t mean to pick on Cramer, who is no better or worse than his stock-picking colleagues. However, it is noteworthy that he recommended Lehman Brothers on Aug. 17, 2007, together with other financial stocks. That day, it closed at $58.11. Its most recent close was around 4 cents.

It may be entertaining to read their musings and watch their antics, but it has nothing to do with intelligent investing.

About the author 

Erik Conley

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

{"email":"Email address invalid","url":"Website address invalid","required":"Required field missing"}