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Is It Really a ‘Stock Picker’s Market’?

Math shows that actively picking stocks doesn’t give you an edge

Birds eye view of the New York Stock Exchange

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Whether we’re having a bull or bear market, it doesn’t matter one iota. So, put arithmetic on your side with another even more important implication.

The U.S. stock market hasn’t moved much this year. As is typical, some stocks have soared while others sank. Perhaps that’s why many articles now state, “it’s a stock picker’s market.” That phrase typically means the overall stock market isn’t a rising tide that is lifting most stocks, so in order to make money you have to be very smart and selective about which stocks you buy. Let’s take a closer look at that claim and examine the facts.

It has been pretty easy to make money in the stock market over the past nine years. The Vanguard Total Stock Market Index Fund Admiral (VTSAX) has increased by 411% in total return (with dividend reinvestment) since it bottomed on March 9, 2009. That’s 19.2% annually through June 20, 2018.  Some think that’s why this fund bested 86% of mutual funds during roughly that same period. It actually bested an even greater percentage because many mutual funds went out of business during those ten years and no longer are counted. This is known as survivor bias.

But has the market really entered a new era with new rules that will allow active managers to regain their former glory by picking the right stocks to hold and avoiding the underperformers? Thanks to simple arithmetic, the easy answer is that it’s impossible for that to happen.

There are roughly 3,610 individual U.S. stocks in that Vanguard Total Stock Index Fund. That excludes some of the smallest companies that are known as bulletin board companies. Some of the companies, like Apple, have a value close to a trillion dollars while others have a value of less than $150 million. The return of the total stock market for any one year is simply the weighted average of the returns of all of these stocks. So, if stocks gain 20%, lose 20%, or just break even, the average dollar invested would gain 20%, lose 20%, or just break even. But that’s only true before fees. If your stock picker (fund manager) charges you handsomely to pick stocks, on average the stocks would underperform by roughly the fees they are charging you.

In fact, in this so-called stock picker’s market, the total stock index fund bested 85% of U.S. broad stock funds year-to-date through June 20, 2018. That’s better than the 55% for the full year of 2017 when stocks rose by 21.2%, including dividends. Understand that these active funds have very sophisticated managers and tools to get the best information to select these stocks. In other words, they have a huge advantage over you and me but still underperform.

Nobel Laureate, William Sharpe, proved this in his paper, The Arithmetic of Active Management. Simply put, this paper asserts that the average dollar invested in the stock market will equal the market’s return less fees paid. It doesn’t matter whether the market goes up, down, or sideways. Ultimately, all that matters is simple arithmetic.

You may, however, be presented with evidence to the contrary. This is sometimes done by comparing returns to the wrong index or, worse yet, comparing the total return of funds with dividends to the wrong stock index and then stripping out the dividends from that index. 

Sharpe’s paper concludes by stating “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

The first implication here is that it will be a stock pickers market only when arithmetic fails. Whether we’re having a bull or bear market, it doesn’t matter one iota. So, put arithmetic on your side with another even more important implication. If you want to do better than most investors, the simple solution is to own the whole market at the lowest costs.