Look Down���and Up
I WROTE ABOUT the perils of timing��the market last Sunday. This week, I���ll address its close cousin: stock-picking.
These days, many people accept that stock-picking isn���t a great idea. Evidence shows that both��professional��and��individual��investors fare poorly, on average, when they choose individual stocks. But why exactly is that? How is it that indexes���which are simply lists of stocks���so frequently outpace the results of professional portfolio managers?
There���s more than one answer to this question. But recent data has highlighted a key explanation. In a��2021 study��of professional portfolio managers, researchers found that fund managers are actually pretty successful at picking stocks. On average, in fact, they outperform with the stocks that they buy. Those stocks went on to outperform by more than a percentage point over the next year.
Instead, the problem is on the other side of the trade. When deciding which stocks to��sell, portfolio managers often fare poorly���meaning they would have done more for their portfolio���s performance by simply selling a random selection of the stocks they own. That, on average, is what causes actively managed funds to underperform. Fund managers��� poor selling decisions more than offset their good buying decisions.
The study explored possible explanations for this phenomenon. Among them: Fund managers get scared when bad news impacts stocks in their portfolio. Every company, almost without exception, will go through difficult periods that weigh on its share price. In many���if not most���cases, companies recover from these rough periods and so, too, do their share price. The stocks may even��outperform��as the dark cloud passes. But in the middle of a crisis, when the news is bad, it can be hard to see the light at the end of the tunnel. That's when portfolio managers tend to react poorly.
Consider this year���s most prominent example: Facebook parent Meta Platforms has seen its stock drop by nearly 40%, wiping out nearly $400 billion of market value. The problem: Apple recently implemented a set of privacy controls that limits Facebook���s ability to target advertising on iPhones. Google has announced it���ll follow suit with its Android platform. The impact has been noticeable. In its most recent quarter, Meta���s revenue and profits rose, but at a dampened rate. Compounding investors��� worries, Facebook also��reported��a decline in user engagement.
Imagine you were a mutual fund manager and owned Meta stock. What would you do? The easy option would be to sell it, take your lumps and reinvest the proceeds in a stock that looks like less of an uphill battle. That may or may not end up being the best decision, but it would be the��easy��one.
The alternative, of course, would be to hold onto the stock. But that would require having faith that it���ll recover within some reasonable period of time. I spoke with one investor last week who worried that it might take Facebook five years to rebuild its ad business. That strikes me as a long time, but right now, it���s anyone���s guess. That, in a nutshell, is why fund managers have such a hard time making good decisions when it comes to selling stocks.
Further complicating matters: Share prices don���t rise and fall in response to just one issue. Investor sentiment, of course, plays a part in moving stock prices. But that���s not all. Corporate boards, management and shareholders all have levers they can, and do, employ to help move prices. These include:
Developing new products or acquiring product lines from other companies.
Spinning off less profitable products or business units.
Cutting costs, including layoffs and other types of corporate realignments.
Initiating a dividend or increasing it.
Initiating or adding to a share buyback program.
Selling real estate���sometimes accompanied by leasing the property back.
Settling a lawsuit or government inquiry.
At the extreme, replacing the CEO or putting the company up for sale.
Sometimes, it takes just one of these actions to spark a share price rally. Corporate managers are highly incentivized, via stock options, to do what they can to move their company���s share price higher.
Other times, this requires outside pressure from shareholders. Activist hedge funds often play this role. I���m not a fan of hedge funds. But they can play an important role in encouraging companies to take action they previously may have resisted. Carl Icahn, for example, was��instrumental��in Apple���s decision to initiate large-scale stock buybacks���a move the company initially fought. Icahn was also behind the 2014��push��to separate PayPal from its former parent, eBay.
The upshot: The outlook for a company���and even the entire market���can look grim, especially if we focus on a single, worrisome issue. But current worries can quickly be forgotten if good news emerges.
There's an expression common among investors, that ���things are never as good or as bad as they seem.��� Right now, of course, things look bad. Vladimir Putin's actions are appalling, and it's hard not to feel uneasy. But who knows? This crisis could end sooner rather than later, and with less loss of life than observers currently fear.
In the meantime, I think it's important, when it comes to your finances, to keep your eye on the long term. Try hard to avoid being spooked by bad news. Just as the fate of any company���s share price never hinges on just one factor, the same is true of the overall market.
Adam M. Grossman��is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on Twitter @AdamMGrossman��and check out his earlier articles.
These days, many people accept that stock-picking isn���t a great idea. Evidence shows that both��professional��and��individual��investors fare poorly, on average, when they choose individual stocks. But why exactly is that? How is it that indexes���which are simply lists of stocks���so frequently outpace the results of professional portfolio managers?
There���s more than one answer to this question. But recent data has highlighted a key explanation. In a��2021 study��of professional portfolio managers, researchers found that fund managers are actually pretty successful at picking stocks. On average, in fact, they outperform with the stocks that they buy. Those stocks went on to outperform by more than a percentage point over the next year.
Instead, the problem is on the other side of the trade. When deciding which stocks to��sell, portfolio managers often fare poorly���meaning they would have done more for their portfolio���s performance by simply selling a random selection of the stocks they own. That, on average, is what causes actively managed funds to underperform. Fund managers��� poor selling decisions more than offset their good buying decisions.
The study explored possible explanations for this phenomenon. Among them: Fund managers get scared when bad news impacts stocks in their portfolio. Every company, almost without exception, will go through difficult periods that weigh on its share price. In many���if not most���cases, companies recover from these rough periods and so, too, do their share price. The stocks may even��outperform��as the dark cloud passes. But in the middle of a crisis, when the news is bad, it can be hard to see the light at the end of the tunnel. That's when portfolio managers tend to react poorly.
Consider this year���s most prominent example: Facebook parent Meta Platforms has seen its stock drop by nearly 40%, wiping out nearly $400 billion of market value. The problem: Apple recently implemented a set of privacy controls that limits Facebook���s ability to target advertising on iPhones. Google has announced it���ll follow suit with its Android platform. The impact has been noticeable. In its most recent quarter, Meta���s revenue and profits rose, but at a dampened rate. Compounding investors��� worries, Facebook also��reported��a decline in user engagement.
Imagine you were a mutual fund manager and owned Meta stock. What would you do? The easy option would be to sell it, take your lumps and reinvest the proceeds in a stock that looks like less of an uphill battle. That may or may not end up being the best decision, but it would be the��easy��one.
The alternative, of course, would be to hold onto the stock. But that would require having faith that it���ll recover within some reasonable period of time. I spoke with one investor last week who worried that it might take Facebook five years to rebuild its ad business. That strikes me as a long time, but right now, it���s anyone���s guess. That, in a nutshell, is why fund managers have such a hard time making good decisions when it comes to selling stocks.
Further complicating matters: Share prices don���t rise and fall in response to just one issue. Investor sentiment, of course, plays a part in moving stock prices. But that���s not all. Corporate boards, management and shareholders all have levers they can, and do, employ to help move prices. These include:
Developing new products or acquiring product lines from other companies.
Spinning off less profitable products or business units.
Cutting costs, including layoffs and other types of corporate realignments.
Initiating a dividend or increasing it.
Initiating or adding to a share buyback program.
Selling real estate���sometimes accompanied by leasing the property back.
Settling a lawsuit or government inquiry.
At the extreme, replacing the CEO or putting the company up for sale.
Sometimes, it takes just one of these actions to spark a share price rally. Corporate managers are highly incentivized, via stock options, to do what they can to move their company���s share price higher.
Other times, this requires outside pressure from shareholders. Activist hedge funds often play this role. I���m not a fan of hedge funds. But they can play an important role in encouraging companies to take action they previously may have resisted. Carl Icahn, for example, was��instrumental��in Apple���s decision to initiate large-scale stock buybacks���a move the company initially fought. Icahn was also behind the 2014��push��to separate PayPal from its former parent, eBay.
The upshot: The outlook for a company���and even the entire market���can look grim, especially if we focus on a single, worrisome issue. But current worries can quickly be forgotten if good news emerges.
There's an expression common among investors, that ���things are never as good or as bad as they seem.��� Right now, of course, things look bad. Vladimir Putin's actions are appalling, and it's hard not to feel uneasy. But who knows? This crisis could end sooner rather than later, and with less loss of life than observers currently fear.
In the meantime, I think it's important, when it comes to your finances, to keep your eye on the long term. Try hard to avoid being spooked by bad news. Just as the fate of any company���s share price never hinges on just one factor, the same is true of the overall market.
Adam M. Grossman��is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on Twitter @AdamMGrossman��and check out his earlier articles.The post Look Down���and Up appeared first on HumbleDollar.
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