I wish we could pick the next Facebook or Google. It would be great for my clients and for me.
It’s not that it’s impossible to get lucky and recommend a stock that turns out to be a “winner”. It’s just that the odds are so poor it makes no sense to try. A better approach is to buy a broadly diversified index fund, which assures returns of the benchmark index, less the low management fees of the fund.
Dismal track record of “experts”
If anyone could pick outperforming stocks, you would think it would be fund managers who run actively managed mutual funds. They are paid handsomely to do this. They have hordes of analysts and a massive infrastructure (like supercomputers), all geared towards one goal: Beating their risk adjusted benchmark.
The most well-known benchmark is the S&P 500 index. It’s generally considered to be the best gauge of large-cap U.S stocks.
There are over 800 mutual funds where the goal is to beat the returns of this index. How did they fare?
Over both the short and (especially) the long-term, most actively managed funds did poorly. Approximately 70% underperformed over both 1-year and 3-year periods ending June 30, 2019. The percentage of underperformance deteriorated to 78% over 5-years, 88% over 10-years and a whopping 87.76% over 15-years.
[Source: SPIVA U.S. Scorecard, mid-year 2019]
Impact of taxes
These percentages are all pre-tax. Because index funds are more tax-efficient than actively managed funds (which have higher turnover), the underperformance would have been worse if calculated on an after-tax basis.
Think about this data: Billions of dollars were invested by those who believed these fund managers could outperform a low management fee index fund that simply tracked the index.
They were disappointed. They would have generated higher returns with the index fund.
That’s the reason we don’t try to pick stock winners.