Stock Picking: Luck or Skill?
Stock picking is like driving the car body of a Lamborghini with a roll of the dice on the engine.
96% chance you get the engine of a lawnmower.
4% chance you receive the engine of a Lamborghini.
On one hand you could get to your destination quickly, on the other, you might as well be better using your own two feet.
This comes from 2017 research from Hendrik Bessembinder, Do Stocks Outperform Treasury Bills. He used the Center for Research and Securities Prices (CRSP) data encompassing U.S. stocks between 1926-2017 finding:
58% of stocks failed to beat Treasury bill returns over their lives.
38% of stocks beat Treasury bills by just moderate amounts
4% of stocks are responsible for boosting the market’s overall returns higher than Treasury Bills
Said differently –
You would be better off taking no risk than holding 96% of the US stock market since 1926.
Yes, there’s a chance you find the next Amazon but at what cost?
1991 research from JP Morgan, The Agony & The Ecstasy: The Risks and Rewards of a Concentrated Stock Position:
Using the Russell 3000 since 1980, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value (this number is higher for Technology, Biotech, and Metals and Mining which had loss rates over 50%).
The median stock return since inception versus the Russell 3000 index was -54%.
This is like playing Russian Roulette but instead of playing with 1 bullet you’re playing with 4.
Many wouldn’t bother messing with those odds, yet many (confidently) do.
Probabilistic thinking as a tool can be used to inform better decision making.
Very few things in the world operate on certainty. Rather, we operate in probabilities to account for chance.
Consider someone who passes away at age 32, does this make you afraid you die at 32 as well?
Given the average lifespan in the U.S. is ~77 years old (& growing) you’d likely caulk that up as an anomaly versus a statistical reality.
Stock picking works the same way.
There isn’t an absolute certainty that you won’t make money, it’s just highly probable that if your goal is long-term wealth generation - individual stocks show low probabilities of success.
This isn’t to say you can’t scratch an itch if you enjoy picking stocks - that’s no problem (I own a very small allocation to individual stocks).
The difference is my financial freedom isn’t predicated on Tesla going to the moon.
So, if you are highly unlikely to succeed picking stocks - why do we still do it?
Stock prices don’t care about your thoughts, feelings, research, & discounted cash flow model (Irregardless of how much we think they do).
This is called the Endowment Effect.
It comes from Nobel Prize Winning Financial Economist Richard Thaler, Daniel Kahneman, & Jack Knetsch in their 1991 paper, Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias they state:
“People often demand much more to give up an object than they would be willing to pay to acquire it.”
Rephrased in the context of the financial markets:
Investors are less willing to sell an asset they own, even if they would not buy the asset at its current price.
If you bought the company at $100/share now it’s $60/share, why wouldn’t you buy more?
Inverted for context - if you had your shares in cash today, would you buy the stock?
The fact you’d rather hold on and not buy more is what Thaler describes as irrational behavior (which helps explain why we stock pick).
We overweight positive outcomes and underweight negative outcomes.
“Everyone wants to get rich quick; no one wants to get rich slow”
Einstein’s theory of relativity did more than just propose how gravity affects space and time; it opened our eyes to consider how our perception differs in relation to the outcome.
Consider this perception warp from Doyle in Interstellar explaining time dilation:
What seems normal to those engaged in the activity appears foreign to outsiders looking in.
Your community plays an enormous role in your perception of the world:
We orbit the sun moving at a speed of 66,660 miles per hour while rotating at 733.65611 miles per hour
Everyone experiences the same gravitational pull → which is why we don’t notice earth’s gravity.
Traveling by plane moving at 600+ mph
Those in the plane don’t notice the plane moving at 600+ mph → those outside the plane notice how fast it’s moving.
Doomsday preppers
They live in constant fear of the world ending → those outside notice how extreme this appears.
If you only hang out, receive inputs, and listen to people who share your beliefs it’s no wonder why you believe what you do.
Today our social media feeds are tailored to our interests to keep us engaged longer, it requires more effort to seek out opposing data.
We are the product of what we consume.
Junk in = Junk out (& vice versa)
When an engineer builds a bridge, they build it so that it can withstand significantly more weight that it will normally carry.
Why?
Failure of a bridge is catastrophic to travelers, capital intensive, & could cost lives.
Applying a margin of safety to your actions ensures you control the outcome.
In a market crash, all assets fall. How much you are able to retain during the recovery far outweighs how much paper gains you make in a bull market.
Upside gain is overrated. Downside protection is underrated.
One pillar of stoicism from Epictetus is the Dichotomy of Control which states any act, thought, behavior, or situation can be broken down into what we can control and what we cannot control.
Stock prices are not up to your control. If it’s not up to you, don’t waste time on it.
Don’t lose sight of the goal of financial freedom in the euphoria of a winning stock pick.
The risks are not worth the reward.