Stock-Picking Is a Fool's Errand

BOSTON (TheStreet) -- In case it wasn't already clear, new studies show that index investing is the way to go.

That means fund managers, advisers and brokers largely don't help individual investors.

Three separate research reports, issued together by the Center for Retirement Research at Boston College, conclude, variously, that individual investors have poor stock-picking skills, investment advisers' advice is frequently not in clients' best interest, and that profits from value-style investing can be, at best, illusory.

All of which, the organization says, "raises serious questions about buying individual stocks or actively invested stock funds."

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And one of the studies even takes on the investment record of the Oracle of Omaha, billionaire investor Warren Buffett, and finds that his long-term results probably aren't repeatable.

Individual investors are woefully ineffective in managing their own portfolios successfully without a modicum of luck, according to a study by four professors at Germany's University of Goethe, published March 15.

They tracked 8,600 individual investor portfolios from a German online broker for five years, through April 2010, measuring their performances against a four-factor model's benchmark "to distinguish skill from luck" in stock-picking success. They found that about 89% of individual investors have "negative skill" since, by their calculations, a portfolio, "with an average level of risk-taking" underperformed the model's benchmark by 7.5% on a gross-return basis and by 8.5% net of expenses.

"It can thus be concluded that the large majority of individual investors do not have the skill to outperform the market -- and if they do, it is mere luck," the study concludes.

Value-oriented investing, which relies on the analysis of financial fundamentals to find undervalued companies, was put under the microscope by Aswath Damodaran of the Stern School of Business at New York University, and found wanting.

"Of all of the investment philosophies, value investing comes with the most impressive research backing from both academia and practitioners," he writes in the April report.

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The excess returns earned by stocks that fit value criteria, including low multiples of earnings and book value and high dividends and the success of some high-profile value investors, such as Buffett, "draws investors into the active value investing fold," Damodaran said.

The study analyzed the relative success of the different types of value investing: passive, built around screening for stocks; contrarian, or investing in companies that are down on their luck; and active, described as taking large positions in poorly managed and low-valued companies and making money from turning them around, in reaching its conclusions.

It found that "while value investing looks impressive on paper, the performance of value investors, as a whole, is no better than that of less 'sensible' investors who chose other investment philosophies and strategies.

"The only funds that beat their index counterparts are growth funds, and they do so in all three market cap classes," it said. "Active value investing funds generally do the worst of any group of funds and particularly so with large market-cap companies."

Buffett's success also gets scrutinized. "Given his track record, you would expect a large number of imitators," said Damodaran. "Why, then, do we not see other investors, using his approach, replicate his success?"

That's because his early successes came at a time when macro-economic risks were mild, he said, and today's market is so much more competitive because information on companies and trading strategies is widely available and dozens of other money managers are also looking for bargains in value stocks.

And, lately, Buffett has adopted a more activist investment style that he has used to good effect, but there are few, if any, big money managers who can duplicate the impact of his influence on a company's management given his reputation, Damodaran said.

Another key ingredient in Buffett's success, his investors' patience, is something that today's money managers don't enjoy as they demand immediate results, he adds.

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And, finally, Harvard professor Sendhil Mullainathan, a special adviser to the federal Consumer Financial Protection Bureau, led a study published by the National Bureau of Economic Research, aimed at testing the quality of advice provided by professional investment advisers to retail investors.

It is based on results of 284 visits to financial advisers in the Boston area between April and August 2008 by "auditors" who impersonated prospective customers for purposes of the study.

Mullainathan and his co-authors found that those advisers tended to give advice that supported the prospective clients' prior beliefs "for fear of losing the client," but at the same time had "no problem discouraging clients from investing more in their current strategies if this is not in the interest of the advisor."

It also found that advisers' recommendations for the same portfolios or investment scenarios presented by the auditors varied significantly. "Most strikingly, they were unsupportive of the (efficient) index portfolio and suggested a change to actively managed funds. Overall, advisers had a significant bias toward active management" and they sometimes "push clients towards funds with higher expected fees with little change in portfolio diversification."

Actively managed portfolios generate significantly more income for financial advisers than do passively managed index funds.

In many instances, it was found that advisers were reluctant to disclose advice about their investment style or the performances before the individual agreed to transfer their account to the adviser's firm, the study found, which "is, to some extent, comparable to a car dealer who asks first for a down payment before agreeing to a test drive of a car."

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