Wednesday, September 29, 2010

Stock pickers claim macro forces are why they can't make money....

An MBA 523 student sent me this link to an article in the WSJ.  It's a great article that argues that correlations between stocks have been increasing, and that a larger proportion of overall stock returns are due to macro economic (or market) factors.

The article mentions a few interesting statistics.  First, the average correlation between stocks in the S&P 500 between 2000 - 2006 was 27%.  At the height of the financial crisis it reached 80% but more recently it has dropped to 66%.  The argument is made that stocks are moving lock step with the market and thus stock pickers trading off firm characteristics can't make a buck.  Second, between 1995 and 2007 about 50% of growth funds beat the Russell 1000 growth index.   But last year only 24% of funds beat the index.

I think a few things are going on here.

First, firm specific risk hasn't gone away.  It's just that market risk is making up a larger component of the firm's total risk.  As my students know (we talked about this last night), as correlations go up, the number of stocks that are needed to create a diversified portfolio increases.   Therefore I imagine that many stock pickers are finding themselves less diversified and, ironically, more exposed to firm level risks.

Second, it is quite possible that markets are becoming more efficient.  The advent of hedge funds and high speed trading, is making it increasingly hard to make a living as a stock picker.

Third, as is noted in the article, making investment bets on macro factors is incredibly difficult.  While stock picking involves making a lot of little bets in many stocks, macro bets usually involve making just a hand full of large bets.  The potential for loosing a lot of money is huge.

It never ceases to amaze me how ordinary people think that they can accurately make these large macro bets.  I read in the money pages of our local Sunday paper about some individual who was asking an "expert" about investing in international stocks.  The individual thought domestic stocks weren't going to do too well over the next few years.

How on earth does he know this?   Would this individual bet on where a hurricane still forming in Atlantic is going to make landfall a week or too later?   No, he'd say that he's not an expert on meteorology and not that even the experts can't predict this.  Yet he'll make a long term macro bet against U.S. stocks.

All of this just reinforces my belief in indexing.   You can't consistently beat the market by trading on your stock picks or your beliefs about macro factors.  At best, all you will do is loose money to fees, but more likely, you'll do something really stupid.