You Don't Suck (at Picking Stocks)

It's become market scripture that individual investors should stay out of the stock game and let the handsomely compensated men and women of the professional investment industry run their money.

But there may be hope for some of the Warren Buffett acolytes out there.

A new working paper suggests that individual investors can show signs of trading aptitude -- or ineptitude. If you've faired poorly in the past, you're likely to continue to do not so great, and if you're consistently beating the benchmark, there's a good chance you'll keep doing it.

Limei Che, Oyvind Norli, and Richard Priestley of the Norwegian School of Management looked at monthly returns for individual investors who held stocks traded on the Oslo Stock Exchange between 1992 to 2003.

That amounted to 718,185 people, or 17 percent of the Norwegian population. Che, Norli and Priestley further winnowed that down to a pool of active investors -- those who traded more than six times over a two-year period. This left about about 65,000 investors. The universe of stocks was limited to the 130 most liquid securities.

Their results show that investors who have done well over a two-to-five year period will outdo a passive market benchmark for up to the next three years. Similar results hold true for investors who did poorly. The results were "unaffected by how we measure past performance, how often investors trade, and whether investors are small or large," the trio wrote.

The researchers also compared a basket of stocks held by the best performing individual investors versus a basket of stocks held by poorly performing investors. Depending on the holding period, the alpha generated by the top performers' portfolio was between 0.72% and 1.25% per month while alpha for the bottom dwellers' portfolio was close to zero.

The findings put an interesting spin on the conventional wisdom that individual investors should be content with receiving the market average return. It seems that if you can somehow identify yourself as a good investor, then it's worth it to keep at it. (And if you do suck, hand your money over to someone else.)

Still, for its uniqueness, the results don't provide much insight into why mutual fund managers (aren't they individuals too?) have trouble outperforming their benchmarks.

In fact, the oft-cited statistic that 75 percent of mutual fund managers can't beat a market index may apply here too. The researchers say a substantial proportion of individual investors can outperform the market, but unfortunately they don't say what that proportion is. (I've gotten in touch with the researchers about this, and will update as soon as I find out more.)

One key reason for this disparity might be that successful mutual fund managers attract more money, (pdf) which has the effect of driving up the cost of doing business and sending returns lower.

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