How Volatility Encourages Investors To Trade

I’ve written many times that traders rarely win in the long-run. However, in this article, I wanted to highlight the fact that the volatility of the stock market blurs how much of investment performance is related to skill versus luck, encouraging investors to trade.

A Thought Experiment

Let’s say that you decided that you would try your hand at stock-picking. For example, since you’re a tech geek, maybe you think you know technology stocks really well and can pick out the latest technology trends and profit from them. Maybe you’re really into fashion and you can tell when brands such as Lululemon or Abercrombie & Fitch will go out-of-style. Maybe you’re a physician who thinks that immunotherapy is the next big thing in oncology and wants to invest in pharmaceutical stocks.

Whatever your reasoning, let’s say you start picking stocks. Of course, you’ll measure your performance, and at the beginning, you’ll do so quite frequently. The thrill of stock-picking is exciting, and I’m sure you’ll track your stock picks at least daily, if not multiple times daily.

How will you know how much of your investment performance is related to your stock picking skill versus luck?

While newer investors may not realize it if they’ve only been investing in the 2010s, but the stock market can actually be quite volatile.

Historical volatility estimates for the S&P 500

Using Portfolio Visualizer’s backtesting portfolio tool, you can look at the historical volatility of the S&P 500. From January 1997 to April 2018, the stock market (as measured by the S&P 500 ETF SPY) has had an annualized return of 8.0% with a standard deviation (a common measure of volatility) of 14.9%. Assuming annual investment returns follows a bell curve, that means that the S&P 500 would return between -7% and 23% in two out of every three years, and between -22% and 38% in 19 out of every 20 years.

Picking Individual Stocks Gets You The Index Fund Return, With More Volatility

Picking stocks in and of itself shouldn’t erode your expected returns before taxes and fees. After all, if index fund investing purports to buy every company in the stock market, then picking one or two individual stocks within that index should give you the same expected return as the underlying index.

The problem with individual stock picking is primarily in its lack of diversification. You get the same return, with a lot more volatility.

For example, let’s look at two individual stocks. Again using Portfolio Visualizer’s backtesting portfolio tool, Bristol-Myers Squibb has had an annualized return of 6.9% and a standard deviation of 25.2% from January 1997 to April 2018. A company like Abercrombie & Fitch has had an annualized return of 7.1% with a standard deviation of 51.4%. Both of these individual stocks have had significantly higher volatility than the overall market.

You’ll notice in the previous example that Bristol-Myers Squibb and Abercrombie & Fitch have had returns that were slightly lower than the S&P 500. Luck goes both ways.

The Probability Of Beating The Stock Market By Chance

What’s the probability of outperforming the S&P 500 by picking an individual stock? Assuming that individual stock returns have an expected return that equals the S&P 500 index, then you would think the number would approach 50%. It turns out that because stock market returns are skewed to the right (positive skew), much of the stock market’s return is clustered in just a few winners, so that the probability is actually less than 50%.

However, by holding a portfolio with a high standard deviation such as one with just a few individual stocks, it is possible to have a return that is significantly higher than the S&P 500 over a long period of time. The problem is that it also makes it possible to have a return that is significantly lower than the S&P 500 as well.

Over time, the standard deviation of your investment returns goes down, but there is still some volatility in your investment returns. Because of this volatility, there are some people who will pick stocks and outperform the market over their entire lifetimes simply by luck. The long-run in the stock market is a very long time. Many investors will never know if their investment performance is due to luck or skill.

Taking Into Account Taxes And Fees

Unfortunately, the expected return of a stock picker is lower than an index investor, after you take into account taxes and fees. Many people who pick individual stocks typically don’t hold them for decades like they might hold index funds. They might hold them for a few years or just a few months. Every time you trade in a taxable account, you have to pay capital gains taxes on any profits, hindering your ability to fully take advantage of compound interest. Trading also incurs fees in the form of commissions and bid-ask spreads, although these factors are relatively small for someone who plans to buy and sell stocks infrequently.

Conclusion

One of the biggest benefits of index fund investing is its simple, inexpensive access to diversification. Unfortunately, the volatile nature of the stock market gives stock pickers false encouragement that they may be beating the market through skill. This can lead to continued trading and inadequate diversification, leading to poorer expected investment outcomes.

What do you think? Do you think investors who beat the stock market attribute their success to skill or volatility/luck?

[Charts courtesy of StockCharts.com]