July 24, 2010

It's A Small World

The notion of "it's a small world" is getting more and more traction in the world of finance these days.  The impact can be seen in ever closer correlations of various stock indices but as John Authors points out in his recent Financial Times article Investors face a world of correlation, the correlation of individual stocks compared to the entire market has been on the rise as well. 

We have long been questioning the concept of stock picking. The idea that the average individual investor would have some special skill or insight into specific companies allowing them to outsmart other individual investors is flawed from the outset.  An average investor is simply that: average; by definition the average cannot outperform the average.  John Authors also points out another recent development, making successful stock picking increasingly difficult.

The problem is that as ETFs account for a greater share of each day’s turnover, so they become more critical in setting the price. If there are big sales of an ETF, it does not sell the stocks that seem most overvalued; it sells stocks in proportion to the index. Hence stocks tend to rise and fall together.

But despite this trend, the financial services industry and its media instigators/collaborators will be adamant and increasingly innovative in generating ideas and trends trying to separate the proverbial wheat from the chaff trying to keep the idea of stock picking alive.  After all, they need you the investor to transact and not just passively sit there enjoying an index fund.  While you consider whether or not to filter out the noise from the financial news channels and just follow a passive index tracking strategy, here's another look at how closely correlated some international markets have been in recent years.  Chances are, we might see increasingly similar correlations among large groups of stocks in coming years.


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