Is successful stock picking a myth? Year after year, the returns of actively managed mutual funds are closely compared to the corresponding index. The best stock pickers may achieve high marks one year and outperform the index, but those returns often decline the next year.

There are high fees associated with managing mutual funds, but a mutual fund can consistently underperform the market.

When mutual fund managers successfully pick stocks, the cost of active management is worth it. But when the opposite happens, investors typically wonder: Are index funds the better choice?

Choosing Stocks in an Efficient Market

A basic finance course at the college or university level introduced efficient market hypothesis (EMH). EMH theory originated with Eugene Fama of the University of Chicago in the early 1960s and argues that financial markets are, or can be, very effective.

The theory implies that market participants are sophisticated, informed, and act only on the basis of available information. Therefore, all securities are appropriately priced at all times.

While this theory does not necessarily negate the concept of successful stock picking, it does call into question any consistent ability of stock pickers to outperform the market.

The futility of stock selection?

EMH generally comes in three distinct forms: weak, semi-strong, and strong. The weak theory implies that current prices are accurately based on historical prices. The semi-strong theory implies that current prices accurately reflect all historical and publicly available information. And the strong form is the most extreme, implying that all historical, public and private information is included in the price of a security.

If you follow the first form, you think that technical analysis is of little, if any, use. The second form implies that fundamental security assessment techniques are not necessary. The strong form invests in market indices via long-term passive strategies and lets the market play.

Markets in reality

While it is important to study theories of efficiency and review empirical studies that lend credibility, markets are rife with inefficiencies.

Inefficiencies exist because in reality, each investor has an investing style and a unique way of evaluating an investment. We can use technical strategieswhile others can rely on fundamentalsand others may simply use a dice roll or a game of darts.

Some potential for success in stock picking

Many other factors influence the price of investments, from emotional attachment to rumors, to the price of a security and supply and demand. Part of the reason why Sarbanes-Oxley Act of 2002 was implemented aimed to increase the efficiency and transparency of markets so that information could be disseminated fairly.

Although the EMH implies that there are few opportunities to exploit information, it does not rule out the theory that managers can beat the market by taking additional risks. Although most investors have equal access to market information, stock pickers can provide interpretation and implementation of market data.

Title Selectors

The stock selection process relies on the strategy an analyst uses to determine which stocks to buy or sell and when to buy or sell.

Loyalty Pierre Lynch was a famous stock picker who used an effective strategy. Although many believe that he was a very intelligent money manager and outperformed his peers due to his decisions, times were also good for the stock markets; he may have had a little luck on his side.

Lynch was above all a growth-style manager. Yet he also used some value techniques in his strategy, proving that no two stock pickers are the same. The variations and combinations are endless and their criteria and models can change over time.

Does stock selection work?

The best way to answer this question is to evaluate the performance of the portfolios managed by stock pickers. It is also useful to open the debate on active against. passive management.

THE S&P500 generally ranks above the median in the actively managed portfolio, indicating that at least half of active managers fail to beat the market. It’s easy to assume that managers can’t select stocks effectively enough to make the process worthwhile and that all investments must be placed in an index fund.

With management feesTHE transaction fees to trade and the need to hold cash for daily operations, one can understand how the average manager might underperform the broad index due to these restrictions. However, when all costs are removed, the race is much closer.

The essentials

The success of stock picking has always been hotly debated. Academic studies and empirical evidence suggest that it is difficult to successfully select stocks that can outperform markets over time.

There is also evidence to suggest that passive investing in index funds can beat the majority of active managers. The problem with proving one’s stock picking abilities is that individual picks become components of any mutual fund’s total return.

In addition to a manager’s best picks, to be fully invested, stock pickers will undoubtedly end up with stocks they might not have otherwise selected, but did so to stay in popular trends.

It is human nature to believe that there are at least some inefficiencies in markets. Every year some managers succeed at picking stocks and beating the markets, but consistent success over time is the real test.