You might think that professional money managers are very adept at picking stocks that will outperform, but that doesn't seem to be the case.
A new analysis from research firm Morningstar found that 90% of mutual fund managers have picked more losing stocks than winners over the past decade, with success depending on whether the stocks outperform or underperform an appropriate market index – rather than whether they make an actual profit or loss. In other words, a manager could fill a portfolio with a number of laggards and still achieve a positive total return, especially in a fast-growing market. In fact, this scenario seems to occur frequently.
The study examined stock-picking success, or “hit rates,” across several fund categories and found that higher ratios, while helpful, did not guarantee better performance. Even when managers initially have a hot hand, they usually find it difficult to maintain that momentum.
“Picking winning stocks is easier said than done,” wrote Jack Shannon, a senior equity analyst at Morningstar who conducted the study.
“What drives returns is finding and holding on to relatively few big winners,” noted Shannon. That means big, compelling bets on an eventual outperformer are the way to go, assuming those decisions bear fruit.
One conclusion from this study is that you should be skeptical any time a professional or just a friend brags about their stock-picking skills. Another reason is that many managers show hot hands from time to time, but this momentum tends to fade.
A third reason is that index funds, which own a relatively stable selection of stocks without trying to pick outperformers, can provide more predictable alternatives. This is especially true since index funds that attempt to replicate the performance of market indicators such as the Standard & Poor's 500 also typically require lower costs borne by shareholders than actively managed competitors. Lower costs increase this advantage.
The benefits of indexing are nothing new, although the Morningstar study provides new insights. For example, index giant Vanguard reported that 82% of its nearly 220 bond and stock index funds outperformed their actively managed peers in the ten years ended June 30, 2023. Actively managed funds are those where a manager attempts to select stocks or bonds that will outperform the market.
In short, identifying stocks that are likely to outperform is not easy, even for professionals. “Individual investors should keep in mind that when well-resourced professional money managers struggle to get half of their decisions right, the odds are also high for amateurs,” Shannon wrote.
Some indicators point to further gains on the stock markets
Despite the sharp drop on February 13 due to ongoing inflation concerns, the stock market has performed well recently and that could bode well for the rest of the year.
In a positive sign, the Standard & Poor's 500 index closed above 5,000 for the first time on February 9th. When key round number milestones like this are passed, investors tend to jump in, says Adam Turnquist, investment strategist at LPL Financial.
He looked at nine previous S&P 500 milestones over several decades and concluded that stocks tend to continue rising. Of the last nine he studied (when the S&P 500 broke through the 100 to 500 mark and then from 1,000 to 4,000), the index typically held, returning an average of 10.4% over the following 12 months. Investors appear excited by the publicity, and many fear missing out on the rally, Turnquist said.
The stock market posted a modest rise last January, and that too could indicate that 2024 will end in positive territory, Turnquist and Jeffrey Buchbinder, LPL's chief equity strategist, said in a separate commentary. This is known as the “January Barometer” and is an optimistic sign.
“As the year progresses, we expect easing inflation, stable or lower interest rates and an expected increase in earnings to support further modest gains for equities,” they added.
Even the presidential election cycle could provide further impetus to keep the market moving higher. This is the tendency of stocks to rally in presidential election years and years before, such as 2023.
Investment funds celebrate an important anniversary
The mutual fund industry is celebrating the 100th anniversary of the first portfolio of its kind in the United States, when Massachusetts Investors Trust opened its doors in 1924. Few financial innovations since then have had a greater impact, particularly for middle-class investors.
More than 116 million Americans rely on funds to pursue their financial goals, whether for education, home ownership, retirement or something else, noted the Investment Company Institute, the fund industry's trade organization. “Funds are the original and greatest democratizing force in global financial markets,” the group said.
Mutual funds and their close cousins, such as exchange-traded funds, provide access and flexibility for entering the stock or bond markets. They can help investors acquire shares in other areas, including money market products, real estate, precious metals or foreign assets.
They are diversified, professionally managed, inclusive, and affordable for people who only have a few thousand dollars or less to invest.
In addition, funds have become more efficient over time, communicating greater cost savings and economies of scale to their investors. They have become mainstays in company 401(k) plans, individual retirement accounts, 529 college savings programs, and more. In total, the funds had assets of $25.5 trillion at the end of 2023.
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