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 Buffett, for example,

the world's
most successful investor.

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

There's no denying -
Buffett'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,

Buffett'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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