Stock picking makes sense if you believe investing is all about spotting successful companies. But identifying good businesses is one thing. Predicting that those companies’ securities will beat the prices set by the market is another.

The media every day is full of analysts’ views about the merits of one stock over another. This multiplicity of opinions takes in management quality, competitive advantage, product differentiation, balance sheet strength, industry margins and on and on.

The implication in the media coverage is that individual investors should sift through all the opinions to come up with their own views about which companies are the best businesses with the best prospects—and build their portfolios from that information.

It’s a daunting task. And it’s entirely unnecessary. That’s because the market, collectively, has already integrated the views of thousands of highly informed and highly expert investors about each company’s prospects.

All that information and analysis is reflected every day in prices. And every day, those prices change as newinformation comes into the market. So even if you assemble a highly considered, deeply thought-out analysis of a company’s worth, you can easily get it wrong.

Take Australian insurance company QBE. Five years ago, QBE was being widely touted by brokers and journalists as a great long-term buy for investors.

In its ‘Brokers Tips’ column, Australia’s biggest selling newspaper The Herald Sun described the insurer as a good buy at its then price of $23.88.1

“QBE is one of the best-managed insurance groups in the global general insurance and re-insurance industry, with an enviable track record of strong earnings testifying to a first-class business model and conservatism,” the newspaper said.

Around the same time, another newspaper, The Australian Financial Review, described QBE as the safe bet in the insurance sector.2

“Insurance is the management of risk and for investors who want insurance exposure in their portfolio, the play with the least surprises has always been QBE,” the newspaper said, noting that the company had delivered “five years of solid earnings per share growth”.

Now while there is nothing to suggest that any of that analysis was wrong at the time, it didn’t really tell us anything about how QBE might perform over the ensuing years.

In fact, in the five years from September 2009, QBE has fallen by 37%, making it one of the biggest detractors from Australia’s benchmark S&P/ASX 300 accumulation index in that period and contrasting with a 37% rise in the overall market.

Facing significant difficulties in its international businesses, the company has downgraded its earnings outlook four times in two years and recently announced a major asset sales program and capital restructuring to bolster its balance sheet. Remember, this is the stock being touted as the “safe play” in insurance five years ago. Analysts back then had studied the firm’s characteristics and expected future cash flows and applied a required discount rate to derive a fair price for the stock.

Of course, you can get lucky basing an investment strategy around perceived mispricing and forecasts about the economy and market conditions. But that approach rests on a couple of big assumptions—that the market collectively will eventually come around to your way of thinking and that the economy and particular industry will pan out as you imagine.

Still, this view remains the dominant approach in fund management around the world. You gather together a few good ideas about individual stocks and you concentrate your portfolio around those “bargains”.

The problem is there is little evidence that trying to outguess the market prices adds value in the long term. And even if the individual stock ideas do come good, there’s no evidence that traditional managers can do this well enough to cover their costs.

Keep in mind, also, that building concentrated portfolios around perceived mispricing can lead to managers missing out on the best performers. So it’s not just about which stocks they pick, it’s also about which ones they leave out.

An alternative approach is to accept current market prices as a fair reflection of the combined views of participants in a highly competitive marketplace. If you start with the prices, you can begin to identify the securities with higher expected returns.

Diversifying broadly and rebalancing as prices and circumstances change mean you are not requiring just a handful of stocks to do all the work and you are less at risk from stock-specific or industry-specific factors that can blow a big hole in your strategy.

Ultimately, investment is about the future, not the past. Prices are forward-looking and are determined by the expectations of thousands of highly skilled, highly motivated and well informed experts.

So rather than trying to outguess the market, you start by using today’s prices to identify differences in expected returns. Put another way, instead of deciding on desired outcomes and betting against prices, you use the information in prices to improve expected outcomes.

1. ‘Brokers Tips’, Herald Sun, Sept 18, 2009

2. ‘How QBE Plays it Safe in a Risky World’, Australian Financial Review, Sept 22, 2009