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Stock Markets: Is Stock Picking Smart?

May 25, 2013 • Behavioral Economics, Demand, Supply, and Markets, Financial Markets, International Trade and Finance, Money and Monetary Policy, Regulation • 294 Views    No Comments

Buy a diversified fund that has global exposure and charges a minimal fee is the investing advice Harvard Professor N. Gregory Mankiw gave to his mother in a NY Times column. Citing economic research that confirms his recommendation, he sounds convincing.

But not everyone agrees.

First Dr. Mankiw’s position:

We should own stock but investing wisely is tough, even for the professionals. Representing ownership in business firms, stocks have appreciated by 6.9% annually in the long run. And yet, their downside risk makes us uneasy. To hedge that risk, Mankiw says we need a global portfolio but most people have a home bias. Furthermore, even when we cushion the impact of a catastrophic investment by diversifying, demand and supply are still not on our side because stock prices reflect information that most people know. For all of these reasons, Mankiw recommends passive investing in funds like the Vanguard Total World Stock exchange traded fund.

Is he right?

One University of Chicago finance professor says maybe not. He is concerned that most existing studies that condemn stock picking are based on misleading aggregate numbers that display an offset between money makers and losers rather than individual data. Also, he speculates that fee based active management could not have persisted for 60 years if stock pickers were all failing. And he reminds us that markets have undergone crises including a mortgage bubble and a tech boom and bust that create stock opportunities. Essentially his paper concludes that “We don’t really understand the process of price discovery in financial markets, and as a result, passive investing” (like Dr. Mankiw’s suggestion to his mom) “may be less intuitively attractive on second glance.”

Our bottom line: Enabling business firms to raise funds, savers to make money available, and borrowers to use it, efficiently functioning stock markets are crucial for market economies.

Stock Ownership in US

Sources and resources: Here is the Mankiw column and a hat tip to the Conversable Economist for the link to Dr. John Cochrane’s paper on the potential merits of fee based active management. My tables on stock ownership (above) and a wealth of information about income distribution and asset ownership in the US are from this paper by NYU’s Edward Wolff. Finally, for more on stock appreciation, you might look at Jeremy Siegel’s book and for stock markets, this econlife post.

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