November 9, 2017

How Expert Are Expert Stock Pickers?

Filed under: Economics — Tags: , , — Nicholas @ 02:00

Marginal Revolution University
Published on 16 Aug 2016

In this first video in our Personal Finance section of Macroeconomics — and also our new course on Money Skills — we’ll begin to lay out some smart rules for investing.

Today, we’ll tackle Rule 1 — ignore the expert stock pickers.

What’s the basis of that rule? Well, in his 1973 book, A Random Walk Down Wall Street, economist Burton Malkiel made a controversial claim. He claimed that a blindfolded monkey, throwing darts at the financial pages, could select a basket of stocks that would do just as well as a set chosen by the pros.

One of Malkiel’s later students, the journalist John Stossel, set out to test that claim. Stossel did throw darts at the financial pages. The darts landed on 30 companies. Turns out, Malkiel did have it right — the randomly-selected stocks did better than professionally-picked ones.

The point here is, random picking roughly gives you as good results, as trusting the pros. Consider — in most years from 1963-2008, the S&P 500 Index outperformed most of the managed mutual funds. And in a different study, researchers took the top 25% best-performing funds. Two years later, less than 4% of the original set remained in the top quarter. Five years later? Only 1% stuck around.

Basically — past performance doesn’t guarantee future results. Chance often tends to win out.

To show you what we mean, take a hypothetical set of 1000 experts making market predictions. Let those predictions be based on a coin toss. Experts who land heads will say the market will surge this year. Those who land tails say the opposite. At the end of the experiment’s first year, 500 of the 1000 experts will have been right, solely by chance. Now, say the remaining 500 toss again. At the end of the second year, 250 experts will have been right, again by chance. Continue with this logic, and by the end of the fifth year, roughly 32 of the 1000 will have been right, five years running.

Perhaps these 32 will be hailed as geniuses, but remember, they only came about through a coin toss.

So, what’s to conclude from this? Two things.

First, luck and chance matter. In some cases, it can be hard to differentiate luck from skill, as proven by the “genius” 32. Second, no need to spend big bucks on a money manager. After all, the studies prove that random picking often works just as well as professional management.

That said, what if you did have market information? What if you knew something about certain stocks, that made you think they’d do well? Could you beat the market then? That’s what we’ll answer in our next video, when we tackle the efficient market hypothesis. Stay tuned!

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