You Can't Beat the Street; Forget The Individual Stocks And Buy Index Funds

You Can't Beat the Street; Forget The Individual Stocks And Buy Index Funds

July 08, 2023

Occasionally we work with a client who really likes to buy individual stocks. The client might have anywhere from a handful of stocks to several dozen in their portfolio. It’s usually a bit of a hodgepodge. Often, they’ve had a taste of success with their investments. Maybe they bought and held Apple or Amazon stock over several years. Or maybe they inherited stock grandma bought in Walmart when it operated just a few dozen stores in Arkansas.

Those unusual success stories can be a double-edged sword. Yes, the client made some money and that’s fantastic. Often, though, that anecdotal success makes them believe it’s possible to beat the stock market. It’s the reason casinos are happy to see people walk away from a weekend in Vegas with winnings in their pockets. They’ll keep coming back.

Many of us at Aptus have experience in stock research. We’ve seen how the sausage is made on Wall Street and we can say with some confidence that you can’t beat the Street—you are much better off investing in broad index funds. It may be possible to beat the stock market, but if you’re spending time reading this blog, you probably aren’t going to be the one that will beat it.

Sorry, we don’t want to disrespect you. If you’re reading this blog, you’re extremely intelligent [of course]. It’s just hard to consistently and systematically pick a portfolio of individual stocks that beats a simple index fund over time. There are a ton of reasons why this is the case, but we’ll focus on three: market efficiency, competition from professionals and positive skew.

In the mid-1960s, Eugene Fama and other academics developed the Efficient Market Hypothesis (EMH) asserting that stocks always trade at their fair value. This is not to say they trade at the “correct” value, because the future is inherently unknown, but rather they trade at a best estimate of fair value given all currently available information. In the EMH’s strongest form, it would be impossible to find an undervalued stock because the market is constantly adjusting to all public and even private information. There have been many “anomalies” detected in the hypothesis, but the general concept was and still is widely accepted as true. It’s nearly impossible to outguess the market price of individual stocks.

What’s mind-blowing about the EMH is how strong the evidence was that you couldn’t beat the market in the 1960s. Before Excel. Before the Internet. Before Moore’s Law computing. Before SEC fair disclosure regulations. Before artificial intelligence. Before hedge funds. Arguably before professional money management even existed. There were a few hundred CFA charterholders in 1965. Today there are around 200,000.

It’s exponentially more difficult to beat the market today than it was when the EMH was developed. Companies publish all relevant information online and stream all their presentations, which are dissected immediately by analysts and algorithms. With the democratization of information, it’s unlikely you are going to be the first to know.

There are enormous financial rewards to those who can find and exploit an informational edge. Historically most hedge funds charged “2 and 20,” or 2% of assets (their management fee) plus 20% of the fund’s returns (their performance fee). That has compressed to something more like 1.4 and 16.5 for the average hedge fund, but many established hedge funds are still charging performance fees of at least 20%. Think about that. A $1 billion hedge fund could make $20 million if the fund gains 10% in a year…on top of a $10 mil.-$20 mil. management fee!

The stakes are high and the budgets for hedge fund research can be astronomical. Hedge fund managers and analysts are talking to customers, suppliers, partners and anyone else who might have any information impacting stock prices. They’re paying experts and consultants to help them understand new product launches. They’re touring factories in China. They’re using satellite imagery to count cars in parking lots. It would be extremely challenging to beat them to a stone left unturned.

Many of our clients are just as sharp as our former hedge fund clients. But if you aren’t spending 60 hours a week and thousands (millions?) of dollars on research, are you really going to have a consistent informational advantage? If markets are not always efficient and there are opportunities to get an edge, you are probably not going to be the one that does so.

In 2017, Hendrik Bessembinder published a paper with the provocative title “Do Stocks Outperform Treasury Bills?” His study showed that the vast majority of stocks don’t. In fact, just 4% of stocks accounted for all the wealth creation in the stock market from 1926 to 2015. The other 96%, in aggregate, only matched the returns of the 1-month treasury bill.

Mind blown, once again.

How is this possible? Well, large positive returns are more frequent and more impactful than large negative returns. Losers tend to get washed out of the stock market relatively quickly while winners compound their returns over many years. Broad index funds, of course, own all the stocks in the market and so fully realize the returns from those big winners.

This creates a dilemma for folks trying to pick individual stocks. To beat a broad stock market index fund over an extended period, you need to identify, buy and hold most of those rare multi-year winners. In an efficient market with hedge funds scouring the planet for any informational edge, you need to consistently catch the bigguns and hang on. That’s not going to happen.

Hey, if you’ve had good luck picking your own stocks so far take a victory lap and celebrate. Then forget your individual stocks and buy index funds. If you’re hopelessly afflicted with the stock picking bug, which we totally get, set a small amount of money aside for trading. But don’t call it investing, call it entertainment.