Putting the Odds in Your Favor

Most people, if they are given the odds of something happening, will make rational decisions. Odds don’t imply any certainty, especially over small samples, but given a big enough sample they can be helpful.

When it comes to stock picking, it took me about 20 years (apologies to my early clients) for me to finally conclude that the “strong buy” recommendations of our research department had absolutely no predictive value. I (and my clients) just wish I had learned that lesson more quickly. In fact, I remember a study the Wall Street Journal did back in the 90’s that measured the performance of buy rated stocks versus sell rated stocks from Wall Street firms and guess which group did the best? Yep- the sell rated stocks that nobody liked (probably because they had done poorly and therefore became cheap).

For the last 20 years of my career, almost to the date, I have let braver folks than me try to rifle shoot the stock market for the “high conviction” or “strong buy” rated stocks. And occasionally these folks look very smart. But the downside and stress of what to do when a stock you thought was a great company goes down 30%-50% and sometimes more is not something that I miss.

So going back to the odds discussion earlier, the following two charts tell the story better than I can.

What we do know from the world of academics is that the average stock does not do nearly as well as the whole stock market.

The chart below shows the odds of picking a stock that outperforms the stock market is very difficult. Since 1986, almost 70% of the stocks in the Russell 3000 (the 3000 largest companies in the U.S. stock market) have underperformed the Russell 3000 index. And maybe just as important, almost 4 out of 10 stocks rewarded shareholders with a permanent loss of capital (a loss of 75% that never even gets back to 50% of its original value).

Source: Goldman Sachs Asset Management

When it comes to picking individual stocks in the hopes of outperforming the stock market, continuously overcoming the 1 out of 3 odds of doing so, doesn’t appear to be a well thought out investment strategy.

If you look at the previous chart again, look at the far- right hand column of stocks that outperformed the index by more than 100%. Those are the key to investment success. It is that small subset of stocks that provide an outsized portion of the index’s return. And the only way we know that our clients will own that small group of companies is to own them all.

Hopefully now you know why we don’t try to pick individual stocks for the portfolios that we are responsible for. We want to put the odds in your favor.

And one more area where we put the odds in your favor, at least according to a lot of history, are the vehicles we use to implement your investment strategy.

Each year, Standard and Poor’s puts out a study looking at mutual funds that are “actively managed”- meaning that somebody or a team is choosing the individual stocks for the fund and comparing the performance of these “actively managed” funds versus their index. While there is no shortage of very smart people managing money, their ability to consistently do better than everyone else is dismal.

As the chart below shows, we are putting the odds in your favor by using index funds to implement your strategy.

Chart: S&P Global SPIVA report

While there is no certainty in our profession, we do have the ability to put the “house odds”, as Las Vegas might say, in your favor.

As the great author and investor Peter Bernstein said, “I view diversification not only as a survival strategy but as an aggressive strategy, because the next windfall might come from a surprising place.”

Seeing homebuilding stocks doing great in a year when mortgage rates have doubled and seeing energy stocks doing great after President Biden’s election certainly confirm the truth of his quote.

Thank you as always for your trust and confidence in us. As always, please don’t hesitate to let us know if you have thoughts or questions we can help with.

Sincerely,

Beach

Disclosure: Any opinions are those of Beach Foster and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. The information contained here does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Past performance may not be indicative of future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment. Raymond James is not affiliated with Goldman Sachs. Every type of investment, including mutual funds, involves risk. Risk refers to the possibility that you will lose money (both principal and any earnings) or fail to make money on an investment. Changing market conditions can create fluctuations in the value of a mutual fund investment. In addition, there are fees and expenses associated with investing in mutual funds that do not usually occur when purchasing individual securities directly. Investors should consider the investment objective, risks, charges, and expenses of mutual funds carefully before investing. The prospectus, which contains this and other important information, is available from your Financial Advisor and should be read carefully before investing. If you no longer wish to receive this email, please reply “unsubscribe”.