Blog - Investing Notes

November 21, 2005 – The Decline of Stock Picking?

How much buying and selling comes from picking stocks rather than assuring diversification by use of stock indices? Is stock picking a dying practice? In their November 2005 paper entitled "Is Stock Picking Declining Around the World", Utpal Bhattacharya and Neal Galpin model and measure the relative proportions of stock picking and index use in the United States and elsewhere. Their model measures the level of stock picking via the relationship between stock trading volume and firm market capitalization. Using data for stocks in 43 countries (21 developed and 22 emerging) beginning with 1962 in the United States and focusing on 1995-2004 for cross-country analysis, they find that:

• There is relatively more stock picking in emerging markets than in developed countries. During 1995-2004, the maximum fraction of volume explained by stock picking is 63%, whereas in developed countries it is only 45%.
• Stock picking is declining for every country, every stock sector/category and every stock.
• In the United States, the maximum fraction of volume explained by stock picking has declined steadily from a 1960s high of 60% to a 2000s low of 24%.
• Stock picking will eventually settle at 11% of trading volume in the United States.
• In the United States, indexing is popular even in stocks not in the S&P 500 index, although there is more stock picking in small stocks than in large stocks. There is currently more stock picking in AMEX stocks than in NYSE or NASDAQ stocks. There is more stock picking in young firms than in old firms. Stock picking is highest in the telecommunication sector and lowest in the utilities sector.
• In the United States, the fewer the analysts covering a stock the higher the fraction of volume explained by stock picking. In other words, investors who pick stocks seem to avoid stocks covered by analysts.

The authors note that their research, in combination with that of others, suggests that mutual funds generally emphasize diversification over stock picking. They also note that growth in hedge fund investing could revive stock picking.

The following chart, among several interesting ones in the paper, shows a general decline in the maximum fraction of trading volume explained by stock picking since 1962 for all firms in the United States ("Entire Sample") and for 400 stocks selected randomly each month ("Random 400").

The next chart, also from the paper, shows that in the United States, stock picking is consistently more prevalent for young firms than for old firms.

We surmise that two factors have increasingly tilted the playing field away from stock picking: (1) the proliferation of engineered indices and Exchange Traded Funds (ETFs); and (2) a decline in the edge of stock pickers as more and more financial information has become immediately available to all investors/traders via the Internet and disclosure-related market reforms.

In summary, investors everywhere have increasingly embraced modern portfolio theory, emphasizing risk management (diversification) over stock picking. The best opportunities for (diligent) stock pickers are the stocks of young, small, obscure, foreign firms.

For related research, see our blog entries of:

11/15/05 for an examination of stock pickers in action (unusual volume as an indicator);

10/17/05 regarding a downward trend in the returns for big stock pickers (hedge funds);

9/29/05 on the stock picking ability of one of the biggest investors of all time;

6/27/05 noting that stock picking indicates an optimistic outlook;

3/16/05 for evidence that extreme stock picking (portfolio concentration) can work; and,

3/13/05 examining the fairly poor recent stock picking performance of professional analysts.