As explained before, I do not place unblinking trust in any sort of “expert”.  Frankly, I don’t think most experts deserve the credence or deference we are wont to give them.  In today’s internet-based world, many self-proclaimed experts are better at self-promotion than at giving expert advice.

When it comes to incompetent experts, the realm of stock picking is no exception. Keeping with the theme that index funds are good and actively managed funds are bad, let’s look at three reasons why stock pickers have such a hard time picking stocks that will outperform indexes.

Random Events

Let’s face it, the future is just too murky to predict.  Who could have seen the most recent stock bubble coming?  Virtually none of the professional stock pickers did.  Jim Cramer from CNBC’s Mad Money certainly didn’t.  The day before Bear Stearns went under, he was telling people to most definitely not sell their stock; that Bear Stearns was A-OK. The next day Bear Stearns went belly up.

There are just too many random variables that go into the price of a company’s stock: natural disasters, defects in a product, new discoveries, terrorist attacks, the list of variables outside of the company’s control goes on and on.  A popular saying among investors is that stock market predictors exist so that meteorologists (weather predictors) can feel good about themselves.

Falsified Financial Statements

A firm’s income statement may be likened to a bikini—what it reveals is interesting but what it conceals is vital.

–Burton Malkiel

One way today’s fund managers decide which stocks to buy is through a process called Fundamental Analysis.  It pretty much means they look at companies’ financial statements (balance sheet, income statement, etc.) to determine if the stock is undervalued or overvalued.  The problem with this approach is the rise in “creative” accounting procedures.  Accountants are very good at manipulating reports to make everything look rosy.

Here is just one example of creative accounting, taken from A Random Walk Down Wall Street:

Eastman Kodak availed itself of “big bash” accounting write-offs.  Kodak took six “extraordinary” charges during the 1990s totaling $4.5 billion, equal to all the company’s profits over the preceding eight years.  By charging off years of expenses at once, the company could make future earnings look that much better.  It’s like an individual making several years of mortgage payments in advance and then claiming that his income has grown.

Conflicts of Interest

Perhaps the biggest reason stock pickers are unable to accurately predict the future is the inherent conflict of interest that exists in the big brokerage houses.  Individual investors like you and me are the small fries in the investment arena.  For stock analysts, the real money is to be made from investment banks.  Investment banks move billions of dollars every month, so stock analysts want to keep them happy.

One indicator of how much analysts want to keep the big guys happy is in their reluctance to give advice which paints the bug guys’ stock in a bad light.  The analyst is torn: he knows he should tell you to sell the lame stock, but his brokerage house has a relationship with that company and it will hurt their relationship if even hints that their stock is stinky.

Here’s a famous example, once again from A Random Walk Down Wall Street:

In one celebrated incident, an analyst who had the chutzpah to recommend that Trump’s Taj Mahal bonds should be sold because they were unlikely to pay their interest was summarily fired by his firm after threats of legal retaliation from “The Donald” himself. (Later, the bonds did default.)

Trust No One…

When it comes to predicting the future, no one has a harder time than stock fund managers.  Even your local weatherman (or woman) gets it right more often.  There are just too many variables: random events, creative accounting, and conflicts of interest.  So what is an investor like you or me to do?  Choose index funds!

Tags: A Random Walk Down Wall Street, Burton Malkiel, stock picking

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