Why Stock-Picking Does Not Work for Retail Investors

Gambling, lottery, football etc. are zero-sum-games; for one person to win, someone else must lose. Stock market investing is NOT a zero-sum-game. That means, it is possible for everyone to make money even if nobody loses a penny. However, stock markets are zero-sum-game at market-returns. That means, for each guy in the market who has earned a penny beyond what the whole market has returned on average, there must be another guy who has earned a penny lesser than the average market-returns over the same duration. Additionally, every investor pays transaction costs (charges to brokers, fund managers, exchanges; taxes to the government; etc.). After accounting for such transaction costs, equity investing on average will yield lesser to investors than what the broad market on average will.

Anyone can invest in the broad markets by investing in index funds or index ETFs, which requires no effort. By investing in the index, you buy a small fraction of the whole market, and hence, choose to earn the same returns that the broad market provides. This is called passive investing. Since transaction costs in passive investing are very small, the passive investor ends up becoming better-than-average investor.

It is obvious that when someone chooses to invest in individual stocks (active investing), he must beat the market-returns; otherwise it’s a futile exercise. Why put an effort in selecting stocks if you can’t beat the index, while you can easily buy the index without any effort?

Since stock markets are zero-sum-game at market-returns, there is a competition between the active investors to earn above-market-returns. If I earn better than the market-return, someone else must earn less than market-return and vice versa. In such competitions, one must outsmart the others or suffer below average returns. Therefore, by definition, everyone cannot win. To earn better-than-average returns over the long run, one has to have an advantage over other active participants in the market. Such advantage can be in the form of any one or more of these three: information advantage, analytical advantage and psychological advantage.

Information advantage means you have more information about a business at a given point in time than others. In the present era of quick information flow, generally no one can have a significant and consistent information advantage. When you read/watch news about a company, it is already mostly incorporated in the stock-price.

Analytical advantage means you can analyse the information better than others and know which business will flourish in the future compared to market’s expectations. Developing analytical advantage over a very small number of businesses is possible for an individual investor if he manages to be highly insightful and systematic in his analysis. By definition, this is possible for extremely small number of individuals who have time, intelligence and enthusiasm to do that.

Psychological advantage means you have better emotional control than others and therefore don’t get swayed away by irrational optimism or pessimism occasionally prevailing in the market which increase or reduce the price of the stocks irrationally, and can take advantage of such situations being a contrarian. This seems achievable to most investors at first, but it is the most difficult advantage to develop. After all, you are part of the market, and if irrational optimism or pessimism impacts the entire market why shouldn’t it impact you?

Hence, when an investor chooses active investing over passive investing, he chooses to compete with other active investors for additional returns above the market-return, and as a consequence, takes the risk of having to end up with returns less than market-return. However, very rare individual investors can develop a considerable competitive advantage needed to compete with the institutional investors. Not surprisingly, most individual investors perform poorly compared to average market-returns. However, not many investors realise this, because (i) they don’t measure their long term performance and compare it with the market-returns, (Earning 10% is a failure if the index has yielded 12%) and (ii) they suffer from a bias where they give more importance to instances when they make money and less to instances when they lose. If you are a common individual investor, active investing is not for you, unless you are one of those extremely rare individuals having one or more of the above mentioned three advantages over others, and can consistently spare time and effort in stock-picking.

What, then, should an individual wanting to invest in equity markets do?

Individual investors who want to invest in stocks have two options left. One is to invest in active mutual funds and have faith that the fund manager (with his team of analysts) has more capability and better chances of generating returns higher than the market-returns. However, after their operating expenses, a large number of active mutual funds will not be able to outperform the average market-returns. The second option is to buy index on regular intervals and be satisfied with the market-returns. This choice will ensure that the investor ends up becoming better than most professional investors! Here is why index funds are the hands-down best choice.

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