Is Stock Picking Really Dead? Part III

Have you ever watched a game of little kid soccer?  Little kids, not big kids.  Here's a hint from my town.  At this age, the moms are not yet soccer moms.  They still think they're hipsters from Brooklyn.  The dads won't show, out of fear someone will recognize them as a New Jersey resident.

Anyway, in Kiddie Soccer, the ball moves randomly.  The four year old kids move randomly near the ball, but not always.  Kid movements correlate poorly with each other and with the ball.  The average location of the kids tells you the ball's location, roughly.  It certainly tells little about the location of any particular kid.

By age six, the kids all chase the ball well.  The dense pack of furious kickers sticks closely to the ball!  The average location of the kids tells you the precise location of the ball.  Not only that, it tells you pretty well location of each and every kid!  Correlation with each other kid (and the ball) rises.  The ball, more or less, still moves randomly, but even without seeing it, you know where it is.

[Maybe by high school kid movements have lower correlation with each other: They stay in position on the field.  And, ball movements get predictable: running and passing in the right direction to reach the goal.]


Keep these images in mind.  They'll help in my third post on the death of stock picking.  In the first and the second, I explained that a tendency by stock pickers to buy smaller and cheaper (in a technical sense) companies helped their performance dramatically in the post internet bubble period, right up until the "Great Recession" began, and those tendencies have been a headwind ever since.  Hence, the systematic death of stock picking.

This post, about correlation, will also help explain why, in the original WSJ story, everyone seems to argue macro investment themes are the way to invest today.

This discussion is difficult.  Please bear with me.  You need to understand how correlation across stocks affects the chances that stock pickers can outperform, through luck or skill.

A stock index, like the S&P 500, is a market capitalization weighted average of a bunch of stocks, meant to reflect "the market".  Imagine the S&P 500 like the soccer pack.  The index could move up, with all companies in a tight pack around the average.  The index could move down with companies all behaving very differently, or any other combination in between.  Does this make sense? Let's hope so, because it's time for a...

Pop Quiz!  

Question 1: What must be true for the S&P500 to move down with all companies bouncing in different directions?  Answer: The biggest companies must fall!  They make up a greater share of the index.If the biggest companies go up, the chance that the index rises must, well, fall.

Question 2: If the S&P 500 moves up, could 480 of the stocks in it be falling?  Yes. Remember, the biggest companies have the greatest influence on results.  So, if the 20 biggest companies win a little, that could overwhelm 480 little losers.  What about an index of the same 500 names that weights them equally?  Still possible, but somewhat less likely.  The 20 winners would have to go up more than the 480 losers.

Okay, still with me?  Good.  Suppose 10 portfolio managers each pick 10 stocks for their portfolio randomly, and they'll hold 10% positions in each of them.  If all stocks are highly correlated (the tightly grouped pack of soccer players) then random picking doesn't lead to much variation in outcomes. All the managers will look pretty much the same after the fact.  And, they'll all likely look pretty much like the index.  The same holds if they have skilled picks instead of random picks.  A portfolio of the ten best stocks may not perform substantially better than the ten worst.

However, if correlations are very low, 10 random stocks picked by 10 managers could result in vastly different results.  Obviously, if a manager picks a top outlier, she has a 10% position in a huge performer.  Similarly, if bad luck strikes and she has a bottom outlier, her business has ended. 

But, just as importantly, outcomes will look very different if any of the outliers happen to be heavily weighted in the index.  

Take an extreme example: 498 stocks are flat.  One rises by 100%, one goes bankrupt, (falls by 100%.) First, assume these outliers are very small index components, say 0.01% of the index, (like New York Times Co and Eastman Kodak Co.)  If your portfolio has the winner, you're hailed as a genius because your portfolio is up 10%.  If your portfolio has the loser, you're going out of business.  If you had neither, you're muddling along like the index, and like everyone else.

Now assume the winning outlier contributes hugely to the index, like  Exxon Mobil, at over 3%.  If you didn't randomly (or "skillfully") draw the winner, you're out of business because you underperformed the index so badly.  Nothing else really matters.

What does this mean for the death of stock picking?  Correlation helps drive periods when stock picking looks good.  When correlations across stocks are very high, zero-skill punters on stocks can hide in the pack, and high skill pickers have a hard time differentiating themselves.  Similarly, when correlations are low, lucky managers with no skill can look pretty darn smart, while skilled stock selectors could be hurt by bad luck.

Now, back to the WSJ story: Is stock picking dead?  In Part I, we saw size biases made stock picking easy in the post bubble period and hurt in the most recent environment, independent of skill.  In Part II, we saw the well documented "value" approach to stock picking that usually helps actually hurt.  Finally, we see that in periods of high individual stock correlation the stock picking game gets even harder.

What's an investor to do??