Stockpicking or Indexing: A 2012 Market Study

US News

I recently released a report on the 2012 performance of the individual stocks in the Standard & Poor's 500 index. This was a banner year for individual stock pickers compared to, for example, active fund managers or to previous years, where, through 2008, 64 percent of the Russell 3000 index stocks underperformed the overall index.

How good was it to randomly pick an individual stock versus just investing in the index?

The S&P 500 performance in 2012 was an 11.7 percent gain. Of the 495 stocks which remained in the S&P 500 from the first day of trading in 2012 until the last day of trading, 46 percent of them outperformed the average. So, if you used a random number generator to pick one of those stocks, the index would have beaten you 54 percent of the time.

It would be easy to start to think that you could use your superior knowledge of the stocks and the markets to pick a winner. If that's the case, then you're letting your limbic system and its inability to do math get ahead of you.

First off, let's look at the average compared to the median performance of the stocks in the S&P 500. The average--the sum of all of the advances and declines divided by the number of stocks weighted for market capitalization--was 11.7 percent. However, the median--the number which means that half of the stocks will perform better and half of the stocks will perform worse--was 10.6 percent. That's a significant difference.

Why is this the case?

The answer is in the extremes of performance. Before we see how these extremes affected performance, let's look at an example of how we miscalculate extremes using an example from Nassim Nicholas Taleb's The Black Swan:

Take a room of 100 people and get their average weight. The average weight for males is around 180 pounds and the average weight for females is around 160 pounds. If you put the heaviest person in the world in the room, the average weight will only skew by one to two pounds.

If you take the average net worth of the people in the room, you'll get about $77,000. However, if you add Carlos Slim to the room, the average net worth increases to approximately $683 million.

In the case of the S&P 500, if we look at top performers versus bottom performers, we'll see a disparity. It's impossible to lose more than 100 percent value in a stock, but it is possible to gain more than 100 percent in a year. Five stocks did just that: PulteGroup, Sprint Nextel, Whirlpool, Expedia, and Bank of America all gained more than 100 percent in 2012. If you just look at top performers compared to bottom performers, you could be led to believe that it's better to pick individual stocks, since that's where the outsized gains occur, particularly compared to what could be lost.

Nevertheless, take out the top 10 performing stocks from 2012, and the average return drops 1.9 percent. On the other hand, among the dogs of the S&P 500, the bottom 10 which included Apollo Group, Advanced Micro Devices, Best Buy, Hewlett-Packard, and J.C. Penney, overall performance only improved 1.2 percent. This means if you missed out on an extreme of performance, your overall return was significantly worse than the average.

The S&P 500 is a market-weighted index, meaning that the biggest stocks in the index by market capitalization have the most disproportionate impact on the performance of the index. In 2012, an equal weight fund would have performed better; the equal-weight average performance was 13.1 percent. Funds such as the Invesco Equally-Weighted S&P 500 Index Fund invest in this manner; however, you pay 0.6 percent in fees compared to 0.17 percent for the Vanguard S&P 500 Index Fund.

Thus, while you would have had a better chance at having outsized returns--12.5 percent of the stocks returned greater than 35 percent in 2012--you'd also have a better chance of missing and underperforming the market. Last year was an outlier for picking individual stocks compared to the index, and even so, picking the index was still a better option. You may think that you're the next Warren Buffett or Benjamin Graham, but the numbers suggest that your chances aren't very good; if you want to go that route, try hedging against failure by keeping investments in the index as well, though nobody can guarantee returns using either method.

Jason Hull is a candidate for the CFP(R) Board's certification, is a Series 65 securities license holder, and owns Hull Financial Planning.

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