How Expert Are Expert Stock Pickers?

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[Alex] The world of investment advice
is a crowded and noisy place.

The good news is,
you can turn down the shouting.

And you also don't have
to follow stock quotes

minute-by-minute in order
to be a smart investor.

In the next few videos,
we're going to lay out some rules

for smart investing.

No, we're not going to tell you
how to get rich quick,

but we will give you
some good advice

for getting richer
slowly and steadily.

Now let's start
with Investment Rule #1,

"Ignore the expert stock pickers." What if I told you
that a blindfolded monkey throwing darts

at the financial pages could select a
basket of stocks that would do just as

well as one chosen by the experts?
That was the controversial claim made

in 1973 by economist Burton Malkiel, in
his book, A Random Walk Down Wall Street.

Years later, one of his undergraduate
students turned out to be

journalist John Stossel. And Stossel,
he set out to test this claim. Now,

blindfolded, dart-throwing monkeys, they're
not easy to come by and the lawyer's a

little bit worried, so Stossel
threw the darts himself.

- [John] My darts landed on 30 companies.
How would they do compared to the stocks

recommended by managed mutual funds?
Oops! Better!

- [Alex] Sure, Stossel got lucky on his throws
and he reaped high returns. But the lesson

here turns out to be correct. Random
picking does just as well as the

professionals. Let's take
a closer look. Most people

invest in the stock market by buying a
mutual fund, a portfolio of assets like

stocks and bonds managed by professionals.
There's thousands of mutual funds. Some of

them are actively managed. They have
experts picking stocks and charging fees.

The other type of mutual fund is called a
passive mutual fund. Passive funds don't

try to pick winners or avoid losers. They
simply invest in a big basket of stocks

such as the S&P 500. Now this
chart shows the percent of mutual

funds that were outperformed by the S&P
500. You can see that in most years, the

S&P 500 beat a majority of the actively
managed mutual funds. Okay, so perhaps

you're thinking, "I got it. Most mutual
funds don't beat the market, but what if I

invest in the ones
that do beat the market?”

The problem with this strategy is that the
funds that beat the market are different

every year. In other words, past
performance does not predict future

performance. The funds that beat the
market this year - they probably got lucky.

And they're unlikely to beat the market
next year. In fact, one study looked at

the 25% best-performing funds. How many of
these funds were still top performers just

two years later? Less than 4%.
And after five years, only 1%

of the initial top performers remained in
the top quarter. So funds which are great

this year - they're probably not going to
be so great in the future. They probably

just got lucky. Okay, what about those
very, very few funds that do beat the

market over many years? Hasn't Warren
Buffet, for example, the world's most

successful investor. Hasn't he shown
that you can beat the market? Maybe.

There's no denying - Buffet's a very smart
guy; he's made some very good choices. But

it's actually harder to distinguish luck
from skill than you might imagine. Let me

explain. Imagine that we started with a
thousand so-called experts, except all the

experts do is flip a coin. Those who flip
heads say the market is going to go up

this year. Those who flip tails, say the
market is going to go down this year.

At the end of the year, 500 are going to
be right, purely by chance. Now suppose

that those 500 then flip the coin again, and
they make a new predication. At the end of

the second year, 250 of these so-called
experts, they'll have been right two years

in a row. Again, purely by chance. Now
keep going with this logic. At the end of 5

years, just 32 of the original 1000, they
will have been right about the market 5

years in a row. Now these 32 -
they'll probably be labeled

market geniuses. They'll show up on
television. Their services will be in high

demand. Perhaps some of them will write
books about - how to predict the stock

market and get rich quick. But the laws
of probability tell us, however, is that

out of the initial 1000 experts, about 32
were going to predict the market correctly

no matter what the market did.
So are some market geniuses truly

skillful? Sure. But it also helps to be
lucky. And it's sometimes not obvious which

is more important. In recent years, in
fact, Buffet's investments haven't done

all that well. So lesson number one is
ignore the people who shout stock tips at you.

- [Man] Dividends funded by debt and not
excess free cash flow are just too risky

to own from now on!

- [Alex] And definitely don't pay big bucks
for professional money managers. But what if

you have some information about what looks
like a great investment? Can you beat the

market? Well we're going to cover that
and the Efficient Market Hypothesis

in the next video.

- [Narrator] Check out our practice
questions to test your money skills. Next

up, Tyler will show you how a tragic space
shuttle explosion can teach us about

investing. Click to learn more.

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