The Importance of Stock Selection



The Importance of Stock Selection

By Brett Steenbarger

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June 19, 2006   9:00 AM ET

How important is stock selection to overall investment performance? Consider that if, in May, 2003, you had invested equal numbers of dollars in each of the components of the S&P 500 Index via the Rydex Equal-Weight Fund (RSP), you would be sitting today with a 64% return on your money. If you had purchased the S&P 500 Index outright (SPY), your return would have been only 36%.

Of course, had you avoided large capitalization stocks altogether and simply purchased the Russell 2000 small cap stocks (IVM) on that date, your return would have been about 74%--more than double the S&P 500 Index performance.

But take a look at the chart below, and you'll see a group of stocks that, since 2003, have actually continued a pattern of underperformance that began in 2000. The red line is the S&P 500 Index (SPY). The blue line is the ratio between the growth stocks in the S&P 500 Index (IVW) and the value stocks in the S&P 500 Index (IVE). Notice that, as the overall S&P 500 Index has been in a bull market, growth stocks within the S&P have underperformed value components of that index. Had you purchased the growth stocks in the S&P 500 Index at the start of May, 2003, your return to date would have been about 22%. Your return on the value stocks would have been about 53%.

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Here's a simple litmus test. Ask a typical individual investor to jot down as many stocks and their symbols as he or she can. The odds are good that you'll get a laundry list of issues that have been market underperformers: the large cap growth stocks from the NASDAQ and NYSE. The odds are also good that you'll get fewer names from the lower-weighted S&P 500 Index stocks, the S&P 500 value stocks, and especially from the Russell 2000. The more familiar the company--on average--the worse it has performed. Which is a way of saying that research into unfamiliar issues has paid off.

Oh yes, notice that all of the stocks we've considered are from U.S. markets. Had you invested in Japan (EWJ), your return would have been 101% since May, 2003. German stocks (EWG) returned 99%. And emerging markets (EEM)? Even after the recent selloff, these have returned 153%.

If it's familiar, it's underperformed. It's not a happy thought when you look at the concentration of stocks in most people's mutual funds.

Brett N. Steenbarger, Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and author of The Psychology of Trading (Wiley, 2003). As Director of Trader Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training program for traders. An active trader of the stock indexes, Brett utilizes statistically-based pattern recognition for intraday trading. Brett does not offer commercial services to traders, but maintains an archive of articles and a trading blog at and a blog of market analytics at traderfeed.. His book, Enhancing Trader Performance, is due for publication this fall (Wiley).

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