Much like high school, investing can seem like a popularity contest. Investors are often drawn to large-cap stocks talked about in the media. Or they buy a firm's stock because it manufactures a product (the iPhone, for instance) they like and use every day.
But how often does popularity equate with profitability?
If you're holding the stocks of large companies with bright futures while avoiding those with dimming prospects, your portfolio will inevitably outshine the broader market. But even the pros have a tough time accomplishing this.
Including popular stocks in a portfolio underscores the hubris that drives investors who engage in stock picking, says Mark Yamada, president and chief executive officer of PUR Investing Inc., a boutique investment management firm in Toronto.
"The number one reason we think we can beat the market is that we believe we can," says Mr. Yamada.
But this is a fool's game for most. Consider the S&P's SPIVA Scorecard, which tracks the performance of active fund managers around much of the globe. In 2014, 74 per cent of Canadian equity mutual-fund managers didn't beat the S&P/TSX composite index. Over five years, that number rises to 84 per cent. (In the United States, the numbers are similar.)
"It's very difficult to do, and you never know who's going to do it in advance," Mr. Yamada says, adding that the collection of managers who beat the benchmark changes from one year to the next.
In contrast, active management – also known as stock picking – is generally more effective in overseas, especially emerging, markets.
In India, for example, 76 per cent of fund managers beat the benchmark index in 2014, with 47 per cent doing so over five years.
To Shailesh Kshatriya, director of Canadian strategies at Russell Investments Canada, these numbers demonstrate that the more efficient the market is – where share prices more closely reflect the actual value of the underlying assets – the more difficult it is to beat it, especially with a portfolio of popular stocks.
"It comes down to market efficiency and investment skill," he says. "The less efficient the market, the greater the opportunity is for skilled active management to outperform."
It's not just emerging markets that are generally inefficient. Small-cap listings – lesser known companies with smaller balance sheets – on North American markets also present opportunities for those with the know-how.
With smaller companies, and in less developed markets, "it is possible for a manager to get an edge of some kind," Mr. Yamada says. "But even with that, it's still a flip of a coin whether they can beat the index."
Still, an argument can be made for owning only the largest Canadian companies. In part that's because the biggest listings – Royal Bank of Canada, Valeant Pharmaceuticals Inc., Suncor Energy Inc. and others – make up about 80 per cent of the market capitalization of the TSX composite. And more often than not, the biggest firms outperform the smaller companies on a broad, inclusive index.
Yet investors can simply purchase an exchange-traded fund (ETF) such as the iShares S&P/TSX 60 Index Fund, which holds the largest firms on the exchange at a far lower cost than if they built their own portfolio of stocks. And they would probably achieve similar if not better results, advisers say.
Even David Stanley, the former writer of the popular Canadian MoneySaver's long-running column Beating the TSX, says most investors are best served doing just that.
"The best thing for an individual investor is to put some money into a broad market ETF and leave it there, come what may," he says. The low cost of ETFs – their management expense ratios, or MERs, are often less than 20 basis points – makes them more attractive than other strategies, including DIY portfolios of popular stocks.
Still some investors can beat the market building their own portfolios, including Mr. Stanley. Over the 27 years of writing his column, "my portfolio outperformed the total return index for Canadian blue chip stocks – the TSX 60 – by about 10 per cent on an annual basis," he says.
Mr. Stanley found success relying on widely held blue chip stocks paying steady dividends that increased over time.
Research is obviously central to success with this strategy. The problem is most individual investors are not willing to do the homework, says retail investor Kevin Graham, who writes the blog Canadian Value Investing. Instead, they often rely on hearsay.
Water-cooler stock tips are a recipe for buying high and selling low, he says. And basing choices on media recommendations is also likely to end badly.
"The news they talk about is commonly known already. But if you go read an annual report, for example, you can find things that aren't discussed widely and can affect an investment," Mr. Graham says.
While building a portfolio of popular stocks can be profitable, stock picking must be "a passion," Mr. Graham says. He says he often spends countless hours reading everything he can about a particular company before investing.
"You have to do the work yourself and rely on your own judgment," he says. "And to most people that terrifies them."