Needles in a Stock Picker's Haystack: Can You Find the 4%?

06/30/2017 01:05 pm ET

We all know that over long time periods, stock returns have exceeded bond returns, and bond returns have exceeded Treasury bill returns. From 1926 through 2016, according to data compiled by Ibbotson Associates, large capitalization stocks returned 10% compounded annually, long-term corporate bonds returned 6% compounded annually, and Treasury bills returned 3.5% compounded annually. Thus, the case for investing in the stock market over long time horizons seems clear and unambiguous. Yet how we get to those averages is not as well understood.

While I read many academic studies on investing, unfortunately too few have practical implications or lessons for individual investors. One of the most important studies to appear in many years is a working paper by Arizona State University Professor Hendrik Bessembinder with the intriguing title “Do Stocks Outperform Treasury Bills?” This study reinforces the need for broad diversification and can be used as evidence by both supporters and skeptics of active management.

Professor Bessembinder finds that while the overall stock market averages outperform Treasury bills over the long run, the vast majority of individual stocks fail to do so. Of the 26,000 stocks that have appeared on the Center for Research in Security Prices (CRSP) database since 1926, less than half have generated a positive return, and only 42% have a lifetime holding period return higher than the one-month Treasury bill rate over the same time period.

Quite simply, the outperformance of the stock market is largely attributable to outstanding returns generated by a relatively few stocks. Astoundingly, one third of one percent of common stocks account for half of the net stock market gains (that is, gains over Treasury bills), and less than four percent of stocks account for all of the net stock market gains over the ninety year period covered by the study.

We all realize that outsized gains from purchasing individual stocks is possible. If someone had invested $1 in Berkshire Hathaway at the start of 1965, they would have over $18,500 at the beginning of 2017. That same $1 invested in the S&P 500 index at the start of 1965 (with dividends included) would have grown to slightly over $123 at the beginning of 2017. The problem, of course, is identifying those big winners.

But, buying and holding individual stocks like Berkshire Hathaway and amassing a fortune is the exception rather than the norm. The lesson for investors is that selecting individual stocks is a bit like buying lottery tickets – winners have big payoffs. But, for every Berkshire Hathaway, Apple, or Amazon there are a plethora of losers like Pets.com, ValueAmerica, Enron or WorldCom. Fortunately, unlike lottery tickets the vast majority of stocks aren’t losers, but simply generate pedestrian returns.

The lesson from the study is that active management can be successful, but the odds are fairly long. Stock mutual funds and ETFs are the much safer way to ensure that an investor will earn a return in the ballpark of the long term averages. Selecting individual stocks and not diversifying across many stocks exposes the investor to both potentially huge gains and huge, disappointing losses.

How lucky do you feel?

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