MarkHulbert

Is it a stock market, or a market of stocks?

The market has been unusually selective of late, with an abnormally large percentage of stocks hitting new 52-week lows even as the S&P 500 SPX, -0.61%  was itself recording new highs.

At first glance, that would suggest that stock picking is more important than ever. Not so, according to several academic researchers.

The typical stock always tends to move in lock step with the overall market, they say. That reality is just being masked by the bull market’s strength.

If they are right, it means you are kidding yourself if you think there are greater-than-normal odds of beating the market when picking individual stocks. Buying and holding a broad-market index fund remains the best course of action for most investors.

There is a statistical reason not to take at face value stocks’ recent tendency to march to the beat of their own drummer. Even when a stock’s sensitivity to overall market movements hasn’t changed, it will nevertheless go through periods when it appears to move in tandem with the market and other periods when it doesn’t, according to Brian Boyer, a finance professor at the Marriott School of Management at Brigham Young University.

One factor that has a big effect on stocks’ sensitivity to movements in the overall market: changes in the market’s overall volatility, as measured by benchmarks like the Chicago Board Options Exchange’s Volatility Index VIX, +3.76%   , or VIX.

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Yet those fluctuations don’t mean there has been any real change in stocks’ relationships to the overall market, according to Kristin Forbes, professor of management and global economics at MIT’s Sloan School of Management “It’s an artifact of the statistics that any time volatility decreases, correlations decrease automatically as well,” she says.

This well describes the markets over the past couple of months. After spiking to near 22 in June, in the wake of Federal Reserve Chairman Ben Bernanke’s hint that he might accelerate the timetable for monetary tightening, the VIX has fallen back to its current level, below 15, as have statistical measures of the extent to which stocks are moving in tandem with the overall market.

The other reason to suspect that stocks might only temporarily be out of lock step with the overall market, BYU’s Boyer says, is behavioral. As soon as fear becomes investors’ dominant emotion, it is a good bet investors will run for the exits. In the process, almost all stocks — including those that remain highly profitable and otherwise immune from whatever is causing the downturn — can be punished and quickly get in sync with the overall market.

Consider Wal-Mart Stores WMT, +0.00%  during the 2008-09 bear market. Though both the company’s sales and earnings continued to rise during those years, its stock nevertheless shed 26% as the market plunged.

This behavioral factor means that, in addition to low market volatility recently, another reason why stocks have been acting more independently of late is that the pendulum has swung so far away from the fear end of the spectrum.

The investment implication: Stocks — at any time and with no warning — could once again begin moving in lock step with the overall market. As a result, stock selection has no greater odds of success now than at any other time.

And those odds are depressingly low, according to Terrance Odean, a finance professor at the University of California, Berkeley. Research he and others have conducted, he says, suggests that “less than 1% of individuals who trade frequently can consistently outperform the market through skill. Over the long run, the rest would be better off investing in low-cost index funds benchmarked to the broad market.”

The implication for most of us is that we should invest in such a fund rather than trying to pick individual stocks. The Vanguard Total Market ETF VTI, -0.56%  is the broad-based index fund recommended by David Nadig, head of research at ETF-tracking firm IndexUniverse, based on a number of factors, including expenses, liquidity and how closely the fund tracks the overall market. Its annual expenses are 0.05%, or $5 per $10,000 invested.

If holding such an index fund through a bear market would result in intolerably large losses for you, then you should reduce the amount you have invested in stocks to whatever level you would be comfortable holding throughout an extended decline.

You don’t have to put the nonstock portion in bonds or savings accounts with minuscule returns. One alternative is to invest in international stocks. Though to some extent they move in sync with the U.S. market, they do so much less than the typical U.S. stock. Allocating a chunk of your equity portfolio to international stocks should reduce your portfolio’s volatility.

The arguments in favor of index funds are even stronger for international than for domestic stocks. The fund that Nadig picks is the Vanguard Total International Stock ETF VTSNX, -0.80%  , with an expense ratio of 0.16%.