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Busting The Stock Picker's Market Myth

Apr 21 2014, 9:32am CDT | by

The dispersion among individual stock returns varies over time. Low dispersion occurs when all stocks tend to move in the same direction, and high dispersion occurs when stocks tend to go their...

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14 weeks ago

Busting The Stock Picker's Market Myth

Apr 21 2014, 9:32am CDT | by

The dispersion among individual stock returns varies over time. Low dispersion occurs when all stocks tend to move in the same direction, and high dispersion occurs when stocks tend to go their separate ways. It’s during a period of high dispersion we hear Wall Street gurus proclaim: “It’s a stock picker’s market.” The inference is that it’s easier to beat the market during these periods. That’s not true.

There is no evidence to support the notion that active stock selection is easier when there is wide dispersion among individual stock returns. A new study, titled Dispersion: Measuring Market Opportunity, by S&P Dow Jones debunks this myth. The data suggest that the probability actively managed mutual funds will outperform the market are no higher during periods of high dispersion than low dispersion.

According to the S&P Dow Jones study, dispersion gives us a way to measure the “potential value of stock selection ability.” If stocks are all heading largely in the same direction, (i.e., have relatively low dispersion), in theory, an active stock picker should find it particularly difficult to construct a portfolio that beats a benchmark index. On the other hand, during a period when individual stocks are acting more like independent assets, there should be a greater opportunity for skillful (or lucky) investors to outperform. Of course, there is simultaneously a greater opportunity for the less skillful (or unlucky) investor to underperform also.

Evidence from the S&P Dow Jones Indices Dispersion: Measuring Market Opportunity in Figure 1 shows little relationship between large-cap US actively managed fund success and dispersion of stocks in the S&P 500. Although there is higher dispersion among active fund returns during periods of high stock market dispersion (not shown), this fund dispersion does not increase the likelihood of outperformance by active managers within the large-cap US market segment.

Figure 1: Percentage of outperforming large-cap US equity funds and dispersion of the S&P 500

It’s often helpful to step back from the data and think about things logically. Why should there be a greater percentage of active fund managers who outperform during periods of high dispersion? Does skill increase during these periods? Are there more opportunities to outperform? I find these arguments suspect.

All the active fund managers buy from the same universe of stocks. Some may buy high-performing stocks during periods of high dispersion, but others are buying low-performing stocks. Thus, the only thing that changes is the amount in which the winners win by and the short-fall in which the losers lose by.  There should be no difference in the percentage of winning funds and losing funds, and that’s exactly what the S&P Dow Jones data infers.

Money managers have a number of clichés when trying to promote their services, and “It’s a stock pickers market” is among the top choices. But this is a hollow argument. There’s no extra benefit to using active management during periods of high stock market dispersion. If you’re lucky, you might pick a winning fund that hits the ball out of the park, but if you’re unlucky, you could dig a deep hole for your portfolio.

My advice is to buy the index where you’re assured to receive your fair share of return. I’d rather be certain of a good return with index funds than hopeful of a great one by betting on active management.

See blog disclosure here.

 
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