Why Stock Picking, Timing the Market Are a Sucker's Bet

In two previous articles, here and here I introduced the concept of asset allocation and reviewed its theoretical underpinnings.

But, as they say, where’s the beef? Theory and practice can be two different things. So let’s review one of the most widely cited academic studies on the importance of asset allocation.

The Landmark Study

One of the landmark studies in finance, “Determinants of Portfolio Performance,” was published in 1986 and is still one of the most widely cited studies on asset allocation today. Looking at 91 pensions plans over a 10-year period, the authors determined the relative importance of investment policy (i.e., asset allocation), market timing, and stock picking on portfolio performance.

The most striking finding was that about 94% of the variation in returns is explained by asset allocation, implying that timing the market and selecting individual securities contributed very little to portfolio performance. What this means is that the differences in the returns of a particular fund across time is largely explained by the returns of the particular asset classes.

Initially this study was criticized for some of its methodology, but subsequent studies by the same authors over different time periods and other authors reached the same conclusion. Further, the same conclusions have been reached for international funds as well, so this is a global phenomenon.

The original study concluded that market timing and security selection reduced portfolio performance by about 1% per year, while other studies showed even worse results. This is not to say that some fund managers didn’t perform better than average by picking stocks or timing the market. Rather, it suggests that stock picking and market timing explained very little of the aggregate performance of the funds, and that on the whole it actually detracted from performance.

Practical Implications

So how do you apply these concepts to your investment portfolio?

First, you should ditch stock picking altogether, since it has very little to do with your portfolio returns. It’s one thing to pick stocks for entertainment value, but it’s the wrong way to build wealth.

Second, financial advisors cite this study all the time, but then most of them turn around and invest your money in actively managed mutual funds in which the manager is either timing the market or stock picking! So not only should you ditch stock picking, you should also stay away from actively managed mutual funds.

This week's financial prescription: Avoid stock picking and market timing, and focus on proper asset allocation.