If only you knew the ultimate strategy for choosing stocks. Wouldn’t that be something.
Well, there’s an argument that goes like this: investing follows the Pareto principle or the 80-20 rule, where 20% of investments provide 80% of the gains, so all you need to do for a good stock picking strategy is focus on the 20% of stocks that are going to provide the big gains.
Whether the winning stocks make up exactly 20% is open to debate, but that winning stocks provide the bulk of the returns is beyond doubt.
An example stock might be Amazon, which reached a $1 trillion dollar market cap this year (2018). In doing so, it became the 2nd company to reach this precipice. Apple was the first, just!
According to CNBC, if you’d invested $1,000 dollars in Amazon in May 1997 during the company’s initial public offering it would have been worth $1,362,000 dollars in September of this year (2018). Nice work if you can get it.
That’s a 134390% increase. If only we’d seen that coming! Apple didn’t do too badly over the same time period either, with its own staggering increase of 35960%.
So on paper stock picking looks pretty straight forward. You just choose the stocks which are going to rocket and then sit back and enjoy the ride.
Unfortunately, as you may of guessed. It isn’t that easy. In fact, it is a notoriously difficult thing to do. Even the professionals don’t seem to be able to do it well for very long (if at all).
S&P Dow Jones Indices recently released its SPIVA Year-End 2017 reports. This report compares actively managed funds against indexes. As there are many funds out there that follow these indexes, you could say the comparison is really between actively managed funds and passive funds.
The actively managed funds have an active manager with untold resources to help them with their stock picking strategy. The passive funds just blindly follow indexes.
The results in the US make for very interesting reading:
SPIVA
So over the last 15 years, no matter the size of the company only about 1 in 20 actively managed funds beat index funds. Whichever which way you frame it, that doesn’t look good for active funds.
In other words, the stock picking strategies employed by professionals doesn’t seem to be working.
Pick all of them!
Why do active funds perform so badly? There are many reasons suggested, but one argument stands out: Nobody knows which stocks are going to do well so you are better off holding all the stocks.
Any active decision making may lead to missing out on the biggest gains.
Even really smart people who did actually invest in Amazon in 1997 couldn’t have predicted the extent of the growth. Nobody could. For every Amazon, there are thousands of companies that failed somewhere on the way without anyone noticing.
If you own an index fund that is diversified over many companies, you won’t miss out on the Amazons, because you’ll unconsciously own them.
Put simply, we can’t be sure which companies are going to do well, but if we own them all we can be sure we’ll own the companies which are going to do well!
Pick all of the stocks all of the time!
Along similar lines is market timing. Everybody dreams of buying at the lowest point in the stock market and then selling at the peak, but again this is notoriously difficult to do.
The graph below from Vanguard shows a 30 year period from1986 until 2016. The blue line is the return of the FTSE All-Share Index, which is an index of the UK stock market.
The grey line also shows the FTSE All-Share Index, but doesn’t include the 10 best days. You don’t have to look too closely to see that if you’d have missed those 10 days you’d have lost just about half your return.
Vanguard say:
research indicates that popular gauges such as growth rates, price-to-earnings ratios and profit margins offer virtually no guidance on equity prices over an annual period.
Vanguard
So the ultimate strategy for picking stocks is pretty simple in the end. Pick all of them all of the time!
more on active vs passive investing here