Every so often you hear or read in the financial press the term "stock picker's market" used to describe a particular type of market environment where, supposedly, active investors and managers who attempt to beat the market via stock selection and market timing techniques have an advantage over passive investors who simply attempt to capture asset class returns. The problem is, the stock picker’s market is a fallacy.
The type of market displayed by the S&P 500 Index this year exhibits what would be the classic stock picker's market. On a price-only basis the S&P 500, a popular proxy for the U.S. stock market, is largely flat for the year with some significant ups and downs in between, as depicted. The S&P 500 including dividends is up 4.5 percent year-to-date through September 28 according to the Standard and Poor’s website. Excluding dividends, the index for the same period has been volatile with a high of 7.5 percent for the year and a low of -9.3. The stock picker’s market theory implies a flat but volatile market is the perfect environment for the active investor.
Active investors in this type of market, on average, are picking and holding the right stocks before the upward movement, holding cash and less volatile stocks during the downdraft, and buying the right stocks again at the market bottom. A tiny fraction of active investors may have been so lucky, but Nobel Laureate in Economics Sciences William F. Sharpe disproves the stock picker’s market theory in his 1991 article, The Arithmetic of Active Management.
Alpha is the industry term for superior performance over the market or a particular benchmark. In aggregate, all investors own the market. So, before all fees and expenses, alpha for investors in aggregate is zero. A passive investor’s intent is to simply capture the market return, and, in aggregate, passive investors do so with zero alpha.
If all investors in aggregate and passive investors in aggregate both have zero alpha, active investors in aggregate too must have zero alpha. Thus, active investing is a zero-sum game: Active investors can only win at the expense of other active investors in any time period.
So, the next time you hear or read the term stock picker's market in the financial press remember, the mathematics simply doesn’t add up.
