Friday Finance - how to win a stock-picking contest . . .

. . . and what this tells us about actively managed funds

The situation

You may be invited to participate in a stock-picking competition, perhaps run by your workplace or the financial section of the newspaper.

Let’s say, hypothetically, that you have to choose three stocks for a period of one year. Winner takes all. Mathematically, what would be the best way of playing it?

The strategy

I would recommend randomly choosing three small-cap stocks. And I do mean randomly – use a dartboard or something.

Micro-caps would be even better but they might not be allowed. In any case, go as small as you can.

If you pick three famous, big-cap stocks, you’ll probably place somewhere around the middle because everyone else will do that.

Small caps are volatile. Within a year, they may move a lot – up or down. This strategy will maximise your chances of winning the competition but will also increase your chances of coming dead last.

In a bear market, small caps tend to crash hard.

If the risk of copping the wooden spoon outweighs the benefit of winning the comp – say, you’re in a financial firm or something – then the safe bet would be to pick a few big-caps and come safely around the middle.

The lesson

This is not a lesson in picking stocks for real investments.

However, the competition conundrum tells us a lot about what’s wrong with actively managed funds.

As in the case of employees in a financial firm not wanting to come dead last, fund managers don’t want to do too badly compared to the index or their peers.

Sure, they’d all like to massively beat the index over the year, but how can they do it? The way suggested here: by picking risky, obscure companies that have massive growth potential but might also crash and burn.

They rarely do this because the risk of the crash-and-burn possibility outweighs the benefit of a massive win. It could be career-destroying, not to mention highly embarrassing. What to do?

The safe bet is to stick with big-caps plus a bit here and there in smaller companies with good fundamentals, ensuring broad diversification, with the goal of somewhat beating the market. No courageous bets.

Add to this the fact that most fund managers will have to put their decisions to a committee, each member of which also does not want to be pantsed by the index, managed funds naturally tend towards conservative investment outcomes.

This is why managed funds usually hug the market pretty closely, minus a bit due to fees. A few outdo it by a good margin, a few fall far behind, but in the long run the law of big numbers kicks in and they all fall behind after fees.

I have a little sympathy for fund managers who get totally cleaned up by the market after pushing through some wacky selections. Unlike most, at least they had a shot.

As for those managers who beat the market by a handy margin, the law of return to mean will catch up with most of them eventually.

There are a small number of individuals who may be better off picking their own stocks, but it seems increasingly certain that no one has any good reason to invest in actively managed funds.

Conclusion

If you want to win a stock picking contest, take big risks or go home.

Your retirement savings, on the other hand, are not a competition. You don’t need to beat anybody, you just need enough to retire, so stick with the index if you are young and in the wealth accumulation stage.

If you really want to pick your own stocks, there’s no point diversifying too much or sticking mostly to big-caps. You’ll be putting all that extra effort into research and management just to roughly mirror the index. If you’re not bold enough to pick something quite contrarian, save yourself some grief and index like everyone else.

Whichever path you choose, avoid active funds and their nasty fees.

Good luck.