The Ignorant Investor

One of the articles of faith on Wall Street is that a person can identify stocks that will rise faster than the market overall. The methodologies used by professionals to identify these stocks differ: analyzing the fundamentals, buying the fastest growing stocks and hoping to bail before they run out of steam, studying charts of stock prices. In Wall Street's eyes, it's all good so long as the end result is an increase in the value of the portfolio.

Many finance professors, most famously Burton "Random Walk" Malkiel, disagree with Wall Steet folk. These professors say we can mostly disregard the methods of the professionals, saying that because the variables underlying the changes in price of an individual stock or the market overall are so complex and so reliant on unknown events in the future, nobody can reliably and consistently predict what the stock's price will be in a month, let alone six months, a year, or five years from now. Timing the market's rises and falls, they say, is impossible, and throwing darts at the stock pages are as an effective method for stock picking as anything else Wall Street might come up with.

Well, you can imagine how the theories are received over on Wall Street, where so many jobs are based around identifying the good apples in the barrel and tossing the rest aside. Who would pay the huge bonuses the pros get to do that job if the job was impossible to do? To Wall Streeters, the professors are ignorant meddlers.

This disagreement leaves investors like me in a bind, wondering whether it's better to try to pick stocks, either by ourselves or by giving our money to a mutual fund manager to invest, or whether we should just save a lot of time and effort by investing in a low-cost index fund. I've taken all three routes in the past couple of years, so I can honestly say that I don't know who is right. I sure like the idea of some hugely educated, highly talented fund manager picking winning stocks using his or her finely honed investing skills, but two questions continue to gnaw at me.

First, if Wall Street fund managers are so sure they can pick winners from losers, why do they insist on getting paid out of percentage of assets under management rather than just a share of the annual profits? If they really believe they're going to pick winners, moving to a pure, performance-based compensation system shouldn't bother them at all. Yet year in, year out, they take a flat 1-2% of the assets under management.

Second, why do so few professional managers beat their benchmark averages over the long term? Superior skill, if it exists, should return consistent results. Yet the same managers who kick ass one year with their portfolios usually come back the next year and get their butts whipped by the indexes. I've read many explanations for this phenomena that don't involve luck, but so far no one seems to have a solid answer I can take to the bank.

Don't get me wrong. I would greet the news that mankind had the capacity to consistently pick winning stocks with great joy. Were I to encounter such a fund manager, I would fall to my knees and worship that manager the way evangelicals worship Jesus. Believe me when I say this, for it is true, my brother.

In the end, I suspect there's no way to know whether stock picking really works. My own beliefs on the issue are of no consequence. I'm in the class of ignorant investors and am as incapable of arguing the point conclusively with the professionals on Wall Street or Harvard Business School as I would be arguing theology with the Pope. Right now it's all about what an investor believes is the truth. A matter of faith, really.