Why picking stocks is likely a losing bet

Everyone loves to hear the story of someone who struck it rich by buying some unknown stock for pennies that later turns into a major player, like Apple or Amazon. It maybe gives us hope that one day we might strike it rich with the next great stock!

Unfortunately, recent studies indicate how difficult and unlikely that is for you. (Sorry!)

Dr. Hendrik Bessembinder, of Arizona State University, examined the returns of individual stocks from 1926–2016. Some of the study’s conclusions might surprise you:

  • All wealth creation in the U.S stock market from 1926–2016 above monthly U.S. Treasury bills (about $35 trillion) can be attributed to slightly more than 4 percent of stocks in the aggregate (1,092 top performing companies). This means that the performance of 96 percent of the stocks in the aggregate during that time period only matched Treasury bills.
  • Over half of the wealth creation can be attributed to 0.36 percent of stocks (90 top performing companies).
  • Five stocks accounted for a full 10 percent of wealth creation during that period: Microsoft, Apple, Exxon Mobil, IBM, and GE. (However, be sure to read this entire article to learn more about Apple and GE.)
  • 58 percent of all stocks performed worse than monthly U.S. Treasury bills.
  • More than half of all stocks suffered losses during their existence, with many of those going out of business.

This means most individual stocks were terrible investments.

The only reason the overall market performed well was because a small number of stocks generated enormous returns over a long period of time. Without the contributions of those stocks, average returns would have been very poor, well below the returns on U.S. monthly Treasury bills.

Vanguard came to similar conclusions in a recent study focusing on whether concentrating on a smaller number of stocks led to outperformance from 1987 through 2017 in the Russell 3000:

  • Approximately 47 percent of the stocks suffered negative returns;
  • Almost 30 percent lost more than half of their value; and
  • Approximately 7 percent of the stocks had a cumulative return of more than 1,000 percent.

Again, a few big winners and a lot of losers. “Rather than raise the outperformance odds, increasing concentration lowers them. The less diversified a portfolio, the less likely it is to hold the small percentage of stocks that account for most of the market’s long-term return,” the study concludes.

But, undoubtedly, some people will still believe they can outsmart the markets and pick the next big winner. After all, the studies do reinforce that a few big winners are where the riches are to be made.

It’s tempting to think that you, or some brilliant stock picker, can consistently pick the winners, but even professionals don’t do it very well.

The following table, from Standard and Poor’s SPIVA U.S. Scorecard, shows the percentage of actively managed U.S. stock funds that fail to outperform their respective index over various time periods, ending Dec. 31, 2018.

Interestingly, the longer the timeframe, the worse the relative performance.

For example, for all Large-Cap Funds, over the last five- and 15-year annualized periods, 82 percent and 91 percent of funds underperformed the S&P 500 Index, respectively. The results of these professionals are even worse with small companies.

If professionals can’t consistently outperform the market picking individual stocks, what are the odds that you or even an above average stockbroker will be able to do so?



What do these studies mean for the average investor?

1. It turns out picking big winners in individual stocks is really, really hard, or you must get really, really lucky. Remember, most stocks do not outperform Treasury bills. If you want to try to pick individual stocks, use only a small portion of your retirement savings.

2. Be mindful of the impact that stories of people that got lucky and picked big winners might have on your emotions. While it does happen, the stories can cause us to make big mistakes in trying to get lucky. You could end up losing significant wealth trying to pick the next big winner.

3. The study reinforces the need for broad diversification to avoid the risk of missing the few big winners. Being broadly diversified is the most efficient way to benefit from the market gains of the next big winners because your portfolio is likely to include them.

4. Active stock pickers and actively managed mutual funds tend to underperform the stock market. The results help to explain why active strategies, which tend to be poorly diversified, underperform relative to market-wide benchmarks, Dr. Bessembinder notes in his study.

Apple and GE are big winners cited in Dr. Bessembinder’s study. However, both stocks are also cautionary tales of how hard it is to pick winners.

In hindsight, many tend to think it’s easy to have picked Apple, but, in reality, its stock price appreciation has been anything but predicable.

Look at Apple’s stock price chart below. How many people would have had the patience to stick with the stock for over 20 years, especially after its inception when its stock price went nowhere? Or how many would have had the luck to “discover” it just as it was taking off around 2005? Or would have stuck with it through all its volatility over the last 15 years?

Source: https://www.macrotrends.net/stocks/charts/GE/general-electric/stock-price-history


GE’s stock shows that just because a company was a big winner in the past, there is no guarantee that it will continue to be a big winner in the future. Look at General Electric’s stock price below.

After performing great for decades, its share price fell significantly in the last few years — down about 30 percent annually on average each of the last three years.

There is no way anyone today can accurately predict the future of the company over the next several decades. Apple or Amazon could suffer the same fate.

The media provides a significant disservice for the investing public when it comes to the myth of the big winners.

It touts the stories of the “stocks to buy now” and the stocks that have been big short-term winners to sell advertising. It ignores the fact that for every winner there are many losers.

For every winner like Apple, there is a Blackberry, Nokia, Motorola, and dozens of companies we never heard of that that lost significant value because of Apple’s success.

These studies reinforce the fact that picking big winners in individual stocks is really hard, or you must get really lucky.

For the vast majority of people, it probably is a fool’s errand. Instead, being broadly diversified by owning the overall markets and letting the markets work over decades is the efficient way to benefit from the market gains of the next big winners.

Dean T. Stange, JD, CFP, is a principal and senior financial advisor at Wipfli Financial Advisors LLC.

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