Retail and institutional investors alike have long been enamored with stock picking. On the surface, the logic is simple: find public or private stocks undervalued by the market and reap the rewards when the market catches up to their actual value.
However, despite the allure of stock picking, the reality is that it is a challenging task to do well. One study found that individual investors consistently underperform market indices at an average of 1.5% per year. Further, a Berkeley study finds that “the vast majority of day traders are unprofitable.”
Warren Buffett put it nicely: “I don’t think most people are in a position to pick single stocks.”
Dispersion of returns
One challenge with stock picking is that public and private stocks have different returns. That is, some stocks will outperform the market while others will underperform.
For public stocks, the return dispersion is relatively small. This means there is no significant difference between the best and worst-performing stocks. However, for private stocks, the return dispersion is much larger.
Another challenge with private stocks is accessibility. Many private stocks are not accessible to retail investors. They may be illiquid or require a minimum investment that is too high for even well-capitalized investors.
This lack of accessibility makes it difficult for stock pickers to find private stocks undervalued by the market.
Further, high-quality data is an industry of its own and is critical for stock picking. Unfortunately, there are many challenges associated with such alternative data.
One challenge is data quality. Private companies are not required to disclose their financial information the same way public companies do. This lack of transparency can make it difficult to assess the actual value of a private company.
Another challenge is data sparsity. For many industries and countries, there is a lack of comprehensive data sets on private companies. This lack of data can make it difficult to find undervalued stocks.
Even when data is available, it may not be timely. For example, a company may announce earnings after the stock market has closed for the day. When investors access this information, the stock price may have moved significantly.
The solution: Indexing
In the 1970s, academic John Bogle popularized the concept of indexing. The idea is simple: instead of trying to pick stocks, investors should buy a basket of stocks that represents the market as a whole.
This approach diversifies away individual stock risk, reduces transaction costs, and gives investors access to the entire market, not just the stocks they can find and research.
Indexing is an effective investment strategy for both public and private markets. It’s difficult for managers to outperform the S&P500 consistently. And when it comes to private markets, while individual startups have a high probability of failure, a highly diversified portfolio, such as a VC fund of funds, can be relatively low risk.
In that way, diversified investing in private markets can both offer risk reduction and greater returns. For example, a study by Cambridge Associates found that top-quartile VC funds outperformed the S&P by ~2X over the last 5-, 10-, 15-, and 25-year periods. Even the median private equity fund’s return of 19% is far higher than that of public stocks.
The bottom line
Stock picking is a difficult task made even more difficult by the challenges associated with accessibility and data. However, indexing provides a simple and effective solution for investors who want to participate in the private markets without picking stocks.
With Gridline, you can index the private markets and gain exposure to a wide variety of assets with low capital minimums, transparent fees, and greater liquidity.