How to Trade Without Picking Stocks

. August 9, 2011
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There are very few stock pickers who beat automated trading strategies.

Even if you're really good, picking stocks takes work, so you'll be under-diversified, owning only a few names. With automated trading strategies, the computer does the work for you. This makes it easy to diversify. Unfortunately, some people want the volatility of having only a few stocks, as if large price movements could only exist when the market goes up.

Why Volatility Matters

Let's say that the S&P 500 returned 9% during the period you were picking stocks, and you got a return of 11%. It may look like you beat the market, but if the volatility of your portfolio was double that of the market, the market actually beat you.

Think about that for a minute. Why would someone hire you to pick stocks when he could just leverage 2:1 into the S&P 500 and get a higher return than you with the same volatility? If no one in his right mind would hire you to manage money, why do you hire yourself?

The Evidence

This article at Empirical Finance compares a stock-picker's value fund with two automated strategies. Here are some excerpts:

There ARE definitely some good stock pickers out in the market, but on average, it seems that “good stock pickers” are few and far between when you really analyze their performance over good AND bad cycles. Or as Buffett says, “There are a lot of people swimming naked [when things go wrong].” As a benchmark to assess true “value-add,” I personally like to look at how a manager stacks up against very plain-vanilla (and tradeable) quantitative value models.

First, let’s break down the the theoretical cost and benefits of a stock-picker versus a computer stock-picker (“quant-picker”):
  • Stock-picker Benefit: a concentrated portfolio of names where the manager has high conviction and potentially high alpha.
  • Stock-picker Cost: The downside of this stock-picker is limited diversification.
  • Quant-picker Benefit: Decent alpha and diversification.
  • Quant-picker Cost:  A “shotgun” research approach versus the very precise “sniper” fire research done by stock-pickers.
In the end, theorizing about whether a stock-picker (“they overcome diversification because they are so good at picking stocks”) is better or a quant-picker (“they overcome mediocre alpha by keeping costs low and being systematic”) is better, makes for a great cocktail discussion, but to get the actual answer, we can simply look at data....

While it is true that the Value Trust beat the SP 500 for 15 straight years, it didn’t really add much in terms of CAGR relative to very plain vanilla quantitative value strategies that also did exceptionally well...

Conclusion: ~tie between stock-pickers and quant-pickers during a good market....

Next, let’s look at what happens when the tide goes out to sea in 2008.

When things go bust, the quant-pickers get rocked and the stock-pickers get rocked–all beta gets rocked! However, the stock-pickers are back to SP 500 levels, whereas, quant-pickers are still way above the market. Also, following the tide washing out to sea, when the surf came back in (2009-2010), the quant-pickers carried on with their winning ways against the stock-pickers.

Conclusion: UGLY. Quant-pickers beat stock-pickers on near every dimension I can imagine.
The entire article, including charts and graphs, is worth reading here.

If you haven't thought about using trading strategies before, read this.