The drive to improve and be the best are exemplary ambitions, however, these traits can manifest themselves into significant handicaps when it comes to investing. This is especially true if an investor has picked a few winning stocks in the past and thus has become susceptible to the belief that their success is due to skill instead of luck. Even with the significant growth in the use of Exchange Traded Funds (ETFs) over the past couple of decades, there is still a large number of investors who prefer picking stocks. Recent studies into analyzing the success rates of investing in individual stocks should cause an investor to think twice.
It is a fact that the over the past 50+ years the stock market has averaged higher annualized returns compared to government T-bills, so it may seem counterintuitive to ask “Do [US] stocks outperform Treasury bills?” However, this is the exact question that a 2017 research paper out of the University of Arizona posed. To answer this question, the author used a database of 25,300 US stocks covering a period from July, 1926 to December, 2016. To track the performance of each individual stock, a simple buy-and-hold strategy was used to calculate the cumulative wealth generated (which includes dividends and price appreciation) over each company’s lifespan; the total collective wealth created over 90.5 years was $34.82 trillion (all dollar amounts used are in US).
Proponents of stock picking are likely quick to point out that a buy-and-hold strategy is not realistic, especially assuming one would purchase at the initial offering on the stock exchange and hold it until it was either delisted or until December 31, 2016. This is true, however, they are missing the point. One must step back and look at the big picture to see the most important points of the study’s findings:
1. The returns of the stock market are driven by a very small number of stocks.
Only 5 stocks account for 10.07% of the $34.82 trillion in wealth created and they include: Exxon Mobile ($1,002,144,000 since July, 1926), Apple ($745,675,000 since Jan, 1981), Microsoft ($629,804,000 since Apr, 1986), General Electric (608,115,000 since Jul, 1926) and International Business Machines ($520,240,000 since Jul, 1926). Just 90 firms account for 50% of the created wealth while 1,092 firms account for 100% - in other words, only 4.31% of the 25,300 stocks that existed during this 90.5-year period created all of the cumulative wealth for investors above what T-bills would have earned during the same period.
2. Holding government T-bills is a better investment when compared to the returns of the vast majority of stocks.
Since only 4.31% of stocks created 100% of the cumulative wealth, that means the remaining 95.69% of stocks would have earned the same return as holding government T-bills. It is also worth noting that over half of these 95.69% of stocks produced negative returns, and the most frequent outcome was a 100% loss of capital.
3. Investors severely underestimate the risk of investing in individual stocks.
While there is a premium paid to hold equities over government bonds, that premium is based on the market as a whole and not on an individual basis. Stock returns are heavily skewed and resemble that of lottery winnings – there are a small number of observations with huge payoffs (4.31% of stocks), but there are a huge number of observations where the payoff was either insignificant or experienced capital losses. Since the maximum that can be lost by holding a stock is 100% and there is no maximum on the upside, the few stocks that created all of the wealth dwarf the 24,208 stocks that either underperformed, or had varying degrees of losses, including delisting resulting in a 100% loss.
These three points reinforce the fact that investing is a long-term marathon – it’s not a sprint from one quarter to the next or from one stock to another. The other lesson for investors is taken from the buy-and-hold strategy of this study. It shows that it is better to stay invested in the stock market through all of the ups and downs. Almost $35 trillion in wealth was created despite four massive bear markets where drops ranging from -38.3% up to -83.2% were experienced (the tech bubble bursting, 2000-2002 and the Great Depression from 1929-1932). A properly constructed portfolio that matches an investor’s desire for risk in order to meet their long-term goals is what successful investors should focus on.