You can’t pick a winner but here’s what you can do
Produced by Bloomberg Media Studios in partnership with Standard Chartered.
We’ve all heard stories about someone who bet big on a little-heard-of stock and now drives a Ferrari. It can’t be that hard, right? It’s just a matter of picking the right stock! Yet few of us have met this person, and with good reason: stock-picking rarely works.
Take the Russell 3000 Index as an example. From 1980–2014, around 40% of the stocks in the index posted negative returns, despite the index returning 2,633%.[¹] The median stock also underperformed the market.
“Everybody focuses on the winners,” says Steve Brice, Group Chief Investment Officer at Standard Chartered’. “Nobody talks about that little-known company that looked like it was destined for greatness 20 years ago but doesn’t exist anymore. Everyone remembers the Microsofts, Apples and Googles—the ones that made it big.”
Data from the S&P 500 amplifies the point. Over the 20 years through December 2020, only 22% of the index’s constituents outperformed the index.[²] The median stock returned 63%, while the index’s return was 322%. When a randomly chosen stock has a one-in-five chance of beating the index, picking a “winner” becomes incredibly challenging.
The Challenge of Bias & Emotion
Not only is picking stocks hard, investors tend to get in their own way—especially when emotions cloud their judgement. According to one study, investor panic resulted in a loss of 8-15% of assets over a 10-year period.[³] Volatility exacerbates the problem.
“It’s easy to have high conviction in an idea when it’s doing well or when you first make the investment,” Brice says. “But when your stock is down 30-40%, which often happens in a normal economic cycle, and you’re hearing negative news about the market and the stock itself, you start doubting yourself and make knee-jerk investment decisions.”
The fear of loss leads people to sell when prices are low, while the lure of high returns leads them to buy when prices are high. This vicious cycle can be detrimental to an investor’s goals.
Biases also lead investors astray. A study of 300 professional fund managers showed that three-quarters believed they were above average at investing.[⁴] Many retail investors also overestimate their skill level.
“I always use this analogy: something like 80% of people believe they are better-than-average drivers,” Brice says. “Statistically, that’s simply not possible. Yet, the same is true for individual investors. Many overestimate how good they are at picking stocks.”
Hindsight bias—the feeling that past events were more predictable than they really were and that the investor was right all along—also breeds a false sense of confidence that can push investors towards risky choices.
A Tried & Tested Approach
It’s incredibly difficult to identify winners a priori. If it were easy, everyone would be doing it. Therefore, most people are better off playing the law of averages or outsourcing their investments to professionals.
“If for nothing else, investing in an ETF or outsourcing to a fund manager yields the benefit of diversification,” Brice says. “It reduces the probability of a positive outlier outcome, so you’re not going to shoot the lights out. But you also reduce the probability of a negative outlier outcome, which protects your wealth.”
Standard Chartered approaches portfolio construction by building a strong, diverse foundation across asset classes and pursing select opportunistic ideas on top of that.
“For me, 99% of my portfolio is foundation because I don’t believe individuals have an edge in picking stocks,” Brice says. “The guidance for most people, if not all, should be a preference for foundation investments. We realize that some people want potential bragging rights when they meet their friends. You don’t have to exclude opportunistic investments from your portfolio entirely. Yet opportunistic investments often come at the cost of performance.”
For those keen to manage their own investments, Standard Chartered suggests five fundamental principles to keep their investments on track: (1) Discipline: remain consistent in your approach and don’t let emotions get in the way; (2) Diversification: diversify your investments across assets, sectors and geographies; (3) Timing: time in the market is better than timing the market; (4) Risk & Return: no investment is worth the risk unless you get a return; (5) Protection: protecting your wealth is just as important as knowing how to grow it.
“Investing can get complex really quickly,” Brice adds. “The key is to try to simplify your life. If you stick with the five wealth principles, the rest will follow.”
Now More Than Ever
Never has a strong foundation been more important. The global market rout has left investors around the world scrambling. In September, the MSCI All-Country World Index wrapped its third straight quarter of declines—the first time that’s happened since the global financial crisis in 2008. While investors are hopeful for a turnaround in 2023, Brice remains cautious.
“We still feel that we’re going to get another leg down in equity markets,” he says. “We think that forward-looking earnings are too optimistic in a world where there’s a high probability of recession. In our view, the recession may not be as shallow as economists believe.
“So, the question every investor should ask is, what actions should I take in the next few months to make sure my portfolio is on a sound footing going forward? The answer starts with building a solid investment plan and diversified allocations.”
[¹] Towards a Data Science [²] S&P Dow Jones Indices [³] Financial Planning Association [⁴] Corporate Finance Institute