The Arrogance of Trading

Even fund managers can’t beat a benchmark. What makes you think you can?

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There is a huge industry based on helping investors trade. Online trading is big business, with many firms competing for your business. Online trading firms offer major incentives to encourage trading, including discounted commissions, real-time data, colorful charts, pattern recognition tools, market motion detectors, and all kinds of screens that will help you sort out the bad stocks, so you can trade only the good ones.

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It may be difficult to persuade you this is all errant nonsense. What if you put your house up for sale and 1,000 people looked at it. They all made the same offer: $399,000. Now assume a real estate broker shows up and offers to buy it for $299,000. Would you sell? Of course not. Why do you abandon this logic when it comes to stock trading?

Billions of investors all over the world have access to the same information you do about every publicly traded stock. They are continuously factoring all of this information into the price of the stock. The market price of the stock today is a fair price, based on the collective wisdom of all of these traders.

When you trade stock, you are making two critical assumptions:

  1. The stock is mispriced
  2. The person on the other side of the trade is dumber than you.
  3. The first assumption is demonstrably wrong. There is no basis for the second one.

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    If anyone could successfully pick stocks, you would think it would be the fund managers of actively managed mutual funds, where the manager attempts to beat a designated benchmark. They are paid handsomely to achieve this goal, and have enormous resources at their disposal. What is their track record? A recent study looked at the performance of 2,100 funds over a 31 year period ending in 2006. The study found a pathetic 0.6 percent of the fund managers had legitimate stock picking skill, which was statistically equivalent to zero.

    By giving you the tools to do in-depth research on individual stocks, brokerage firms encourage the myth that your time and effort are likely to be productive. What are you supposed to be researching? When I ask this question, I am often told by investors they are trying to find the next great company. Why is this a good idea?

    An exhaustive study reviewed the returns of Fortune’s list of most admired companies from April, 1983 through December, 2007. It found the stock of the admired companies had lower returns, on average, than the stocks of the spurned companies during this period. The difference was significant. The average annualized return of the less admired companies was 17.8 percent compared to 15.4 percent for the most admired companies.

    It’s hard to accept the fact that no amount of research will help you pick stock winners. Your resources and research skill are dwarfed by those of the big mutual funds. If they can’t do it, neither can you. There’s also a more insidious aspect to all of the hype about doing research and trading stocks. It diverts your attention from the kind of research that is likely to increase your returns.

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    The studies in this blog and hundreds of others demonstrate that stock picking and market timing are not only harmful to your financial health, but basically irrelevant. Instead of focusing on practices that have little likelihood of success, you should be capturing market returns by determining your asset allocation and investing in a globally diversified portfolio of low cost stock and bond index funds. This is an intelligent way to invest. You should opt for intelligence over arrogance.

    Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.