How Expert Are Expert Stock Pickers?

[Man on TV] You'll be under water! You'll be losing money! In other words, the dividend gain is not worth the principal loss. Whoa! I can't take the pain! That's when you want to be a buyer.

[Alex] The world of investment advice is a crowded and noisy place. The good news is, you can turn down the shouting. And you also don't have to follow stock quotes minute-by-minute in order to be a smart investor. In the next few videos, we're going to lay out some rules for smart investing. No, we're not going to tell you how to get rich quick, but we will give you some good advice for getting richer slowly and steadily.

Now let's start with Investment Rule #1: "Ignore the expert stock pickers." What if I told you that a blindfolded monkey throwing darts at the financial pages could select a basket of stocks that would do just as well as one chosen by the experts? That was the controversial claim made in 1973 by economist Burton Malkiel, in his book, A Random Walk Down Wall Street. Years later, one of his undergraduate students turned out to be journalist John Stossel. And Stossel -- he set out to test this claim.

Now, blindfolded, dart-throwing monkeys -- they're not easy to come by and the lawyer's a little bit worried, so Stossel threw the darts himself.

[John] My darts landed on 30 companies. How would they do compared to the stocks recommended by managed mutual funds? Oops! Better!

[Alex] Sure, Stossel got lucky on his throws and he reaped high returns. But the lesson here turns out to be correct. Random picking does just as well as the professionals.

Let's take a closer look. Most people invest in the stock market by buying a mutual fund, a portfolio of assets like stocks and bonds, managed by professionals. There's thousands of mutual funds. Some of them are actively managed. They have experts picking stocks and charging fees. The other type of mutual fund is called a passive mutual fund. Passive funds don't try to pick winners or avoid losers. They simply invest in a big basket of stocks such as the S&P 500.

Now this chart shows the percent of mutual funds that were outperformed by the S&P 500. You can see that in most years, the S&P 500 beat a majority of the actively managed mutual funds. Okay, so perhaps you're thinking, "I got it. Most mutual funds don't beat the market, but what if I invest in the ones that do beat the market?” The problem with this strategy is that the funds that beat the market are different every year. In other words, past performance does not predict future performance. The funds that beat the market this year -- they probably got lucky. And they're unlikely to beat the market next year.

In fact, one study looked at the 25% best-performing funds. How many of these funds were still top performers just two years later? Less than 4%. And after five years, only 1% of the initial top performers remained in the top quarter. So, funds which are great this year -- they're probably not going to be so great in the future. They probably just got lucky. Okay, what about those very, very few funds that do beat the market over many years? Hasn't Warren Buffett, for example -- the world's most successful investor -- hasn't he shown that you can beat the market? Maybe. There's no denying -- Buffett's a very smart guy; he's made some very good choices. But it's actually harder to distinguish luck from skill than you might imagine.

Let me explain. Imagine that we started with a thousand so-called experts, except all the experts do is flip a coin. Those who flip heads say the market is going to go up this year. Those who flip tails, say the market is going to go down this year. At the end of the year, 500 are going to be right -- purely by chance. Now suppose that those 500 then flip the coin again, and they make a new prediction. At the end of the second year, 250 of these so-called experts -- they'll have been right two years in a row. Again, purely by chance.

Now keep going with this logic. At the end of 5 years, just 32 of the original 1000 -- they will have been right about the market 5 years in a row. Now these 32 -- they'll probably be labeled market geniuses. They'll show up on television. Their services will be in high demand. Perhaps some of them will write books about how to predict the stock market and get rich quick. What the laws of probability tell us, however, is that out of the initial 1000 experts, about 32 were going to predict the market correctly no matter what the market did.

So, are some market geniuses truly skillful? Sure. But it also helps to be lucky. And it's sometimes not obvious which is more important. In recent years, in fact, Buffett's investments haven't done all that well. So, lesson number one is ignore the people who shout stock tips at you. [Man on TV] Dividends funded by debt and not excess free cash flow are just too risky to own from now on! [Alex] And definitely don't pay big bucks for professional money managers.

But what if you have some information about what looks like a great investment? Can you beat the market? Well we're going to cover that and the Efficient Market Hypothesis in the next video.