Why Most Stocks Lose Money With Hendrik Bessembinder (EP.259)

0:02The Long Term Investor Host:We all need to make smart decisions with our money. The Long Term Investor Podcast shows you how by distilling complex financial matters into easily digestible lessons. And now, here's your host, Chief Investment Officer at PlanCorp and the author of Making Money Simple, Peter Lazaroff. The stock market's long-term record is one of the biggest reasons investors are told to stay invested. But that record hides a surprising reality. The typical individual stock has not delivered anything close to the market's overall return. And that is why in this episode, I invited Hendrik Bessenbinder, whose research has reshaped how many people think about stock market returns.

0:44The Long Term Investor Host:Hank's work shows that a relatively small number of extraordinary winners account for a huge share of the wealth created by public markets, which raises an important question for anyone trying to pick individual stocks. Specifically, how confident should you be that you can identify those winners in advance? We also discuss why averages can be misleading, how investors should think about the full range of possible outcomes rather than a single expected return, and why the way we measure investment success may not always match the way real people experience it. And towards the end of the conversation, we also explore whether AI could make stock market outcomes even more concentrated or potentially push things in the opposite direction.

1:25The Long Term Investor Host:This is really a conversation about diversification, humility, compounding, and the gap between what the market delivers and what most individual stocks actually do. As always, you can find detailed show notes at thelongterminvestor.com. And at the top of this episode's description, there is a link to get updates on my new book, The Perfect Portfolio, which will be out September 22nd. And now, here is my conversation with Hendrik Bessenbinder.

1:57The Long Term Investor Host:Hank Bessenbinder, welcome to The Long-Term Investor. Thanks, Peter. My pleasure. You know, I have been a big fan of your work. Long-time listeners of the show have heard me reference research you've done on individual stocks. What prompted me to reach out was one of your more recent papers, 100 Years in U.S. Stock Markets. We're going to get to that. We're going to touch on a lot of the work that you've done. But let me start here. There's an interesting stat that I pulled out of one of the papers. the U.S. stock market created about$91 trillion of shareholder wealth over the last century, yet most individual stocks failed to beat treasury bills.

2:35The Long Term Investor Host:Do you think that's the simplest way to summarize the paradox at the heart of your work? Yeah, I think that that goes right to it. The stock market as a whole in the long run has been a tremendous wealth generating mechanism, while at the same time, most stocks underperform. Most stocks in the long run lose money. And, you know, that's a little bit of a counterintuitive finding. It seems like a few people are still resistant to it, but that's the reality. When what prompted you down this kind of path of research that, you know, this is not new. You've been doing this for quite some time. And what made you take note in the first place?

3:16Well, it was a little bit of an accident. As you observe, I've been working in this area for, I guess, close to 10 years now. But it's not where I was working for most of my academic career. I was doing more traditional things, studying factor investing, studying rules for trading and trading costs and such. So this detour into long-run stock market performance and skewness, a term I'm sure we'll talk more about in the next few minutes, was a little bit of an accident. And the answer is a little bit techie, but I was doing a fairly routine study with some co-authors. It involved quite a few stocks over quite a few years.

4:00And for some technical reasons, we were looking at continuously compounded returns, logarithmic returns. And I just happened to notice that for this pretty big sample of stocks, the average logarithmic return was a negative number. And I'm just not used to seeing a negative average return for a big sample of stocks. And the techie thing here is the thing about logarithmic returns is you can add them up cleanly. And then if you want to convert it back to real returns, you have to do the so-called antilog. I warned you, it's a little techie here. But that doesn't change the sign. So the thing is, I'm looking at this data and suddenly it occurs to me, a lot of stocks seem to be losing money.

4:46So it was that aha moment of I'm looking at some sample statistics that make me say, it looks like a lot of stocks are losing money. And then I started digging and I've been digging for 10 years since. And that was right. A lot of stocks are losing money.

5:02The Long Term Investor Host:Well, let's dig into that a little bit. So your most recent version of the research looks at nearly 30 ,000 individual stocks dating back to 1926. And the average individual stock return is very attractive. But the median, that middle outcome, is negative. So for a listener who has never thought about skewness or maybe doesn't even know what skewness is, how would you explain that? I think the reason this is counterintuitive and, you know, in some sense foreign to a lot of people is that we're used to things being kind of symmetric. There's even the bell-shaped curve, the normal distribution that shows up in statistics a lot, which is a symmetric distribution.

5:47And that's what we run into in many walks of life. So let me just take an example. I like this one because I'm of Dutch heritage. And as you may know, there's some studies saying that Dutch people are on average the tallest. So that's why I kind of like to use this for the example. But let's talk about the height of Dutch men. Average right about six feet. There's going to be a lot of Dutchmen that are close to six feet, right around the average. And then as you move away from the average, there's fewer. You know, you take it up to six foot five, there's not as many. Take it down to five foot five, there's not as many.

6:19But it's still kind of symmetric. You take it down to five feet and up to seven feet, there's almost none. in either direction. So that's what a typical symmetric distribution looks like. You have an average and then things are kind of grouped around the average with fewer outcomes as you get further away from the average in either direction. And that's kind of what we're used to most of the time. For compound long run outcomes in the stock market, it doesn't look like that at all. In terms of our example with height, it's more like the average is six feet, but most of the people are under two feet.

7:04And the only reason we have a six foot average when most people are under two feet is that we have some people who are 35 feet or 150 feet. That's skewness or if you prefer really just asymmetry. Those are those are reasonably substitutable terms. What we have in stock market outcomes is is asymmetry around the average.

7:29The Long Term Investor Host:And so, I mean, really just a couple winners lift the whole boat. Is that fair? Yeah, essentially. I mean, the only way you can have that the overall market does quite well, We have a very substantial equity premium. The overall market does quite well, while most stocks lose money. The only way those can both be true at the same time is that you have a relative few that are doing great and are pulling up the average to where the average is not representative of the typical stock. So that's what's going on in a nutshell. I'm going to butcher some of these stats probably a little bit. And so you correct me where I'm not getting it right.

8:07The Long Term Investor Host:But you reference shareholder wealth creation from individual stocks and how just such a small percentage, like half a percent of all stocks. I can't remember if it's created half of the shareholder return or maybe it's all of it. I mean, maybe explain that. There's buy and hold returns. I think that's what a lot of people think about. But there's this other metric that you're looking at, shareholder wealth creation. Can you unpack that a little bit? Yeah, sure. And let me just broaden that a little bit. One of the recent papers I wrote after having been thinking about these issues for eight or nine years is titled, How Should Long-Term Outcomes to Investors Be Measured?

8:47And it's not as obvious as you might think. You know, we have some measures that are relatively familiar, but it's not entirely clear that those familiar measures are the best or the right way. So a buy and hold return is a pretty simple thing, and the name describes it. If somebody just put some money in and didn't trade anymore, there's one technicality there. You have to be reinvesting your dividends to earn the buy and hold return if they're computed from dividends, sorry, returns that include dividends. But other than reinvesting dividends, the buy and hold return is just what the name says.

9:21So that's a simple thing, and I report it, and it's informative to know how that turns out. But the thing is, we're not buy and hold investors. almost nobody is. You know, we either add to our investments from time to time or we pull money out of our investments from time to time. And here's a really important distinction. You know, one investor hypothetically could be a buy and hold investor. But the group of investors, you know, the body of people who invest in the stock market are not buy and hold investors. How do we know that for sure? Because firms do primary transactions. They issue shares, they repurchase shares, and shareholders, investors in aggregate are on the other side of those transactions.

10:09And for that matter, collectively, we don't reinvest dividends. That idea sometimes surprises people because it's so easy for any individual to reinvest dividends. but if I reinvest my dividend, what I'm doing is buying some more shares and that requires that somebody else sells shares. You know, my buying some more shares doesn't put the money back in the company. So anyway, collectively, we don't reinvest dividends. So anyway, this second measure that I have in most of my papers, shareholder wealth creation, it differs from buy and hold returns in two key ways. The first is it takes size into account.

10:52Other things equal a big investment. You know, a 5 % return on a big investment involves more dollars than a 5 % return on a small investment. So it takes size into account. And then it takes into account that it takes the perspective of shareholders in aggregate. So not a buy and hold perspective, but a perspective of investors who did participate in share offerings, did participate in share repurchases, etc.

11:19The Long Term Investor Host:As you were saying that, I looked up the stat that I knew I was going to butcher and I did. I did butcher it. So we'll get this correct this time. But the paper of yours about a decade ago that a lot of people like myself latched onto looked at all of the existing U.S. listed, well, existing and historical past listed companies from 1926 through 2016. And at that point in time, there were 90 firms that accounted for half of this net shareholder wealth creation that you captured. Now, we fast forward to the present and you see that that same number is covered by only 46 firms. So like what has changed?

11:59The Long Term Investor Host:That's a big change. And first of all, actually, let me step back. First of all, let's acknowledge that just a very, very small portion of individual stocks drove most of the wealth creation. And so, you know, maybe an obvious takeaway for diversification and owning a little bit of everything is that if you don't own a little bit of everything, the risk of missing where all that wealth creation is coming from is quite large. The other thing that stands out to me, though, is, wow, like data sets don't typically change that much in such a short period of time. So go either way you want with either of those takeaways from myself.

12:35The Long Term Investor Host:I'd just love to get your thoughts on those on those items. Sure. So there's a couple of things there. One is the desirability of diversification. Let's maybe come back to that in a minute because it's a topic that deserves its own focus. But the concentration of wealth creation. So let's take it in two steps, as you did. in the original study, I documented what I thought and what most people thought was a remarkable degree of concentration and wealth creation with a relative handful of firms accounting for half. And there was another statistic, about 4 % of the firms accounted for all of the net wealth creation.

13:15So I was surprised, I think a lot of other people were surprised at how concentrated the wealth creation was, how few firms were driving it. The second thing is there's only nine years of additional data. The first study had 91 years of data. Now we're up to 100 years of data. But in only nine additional years, the number of stocks that account for half of the wealth creation decreased a lot or more or less was cut in half. So that's really striking as well. In terms of what changed, this is something that is not yet in a paper that I've circulated publicly, but it's in a paper that I expect to post publicly probably within a week or two.

13:59But what's changed is that if you went back over the last 60 or 80 years and said, instead of buying everything, I'm going to buy just the biggest stocks, maybe the single biggest stock, maybe the 10 biggest stocks. For most of the last 50 or 60 years, that has actually not worked out well. But it changed at about 2013. And since 2013, it's worked out very well. The big firms have outperformed since about 2013. And in a nutshell, that's why we, that unusual pattern where the big firms outperformed by quite a bit, that has shown up in the last dozen years is why we've seen this sudden acceleration in how concentrated the wealth creation is.

14:49The Long Term Investor Host:People are going to recognize some of these big names, Apple, Microsoft, Alphabet, Amazon, NVIDIA. I believe it's NVIDIA that had the highest annualized return among stocks with more than 20 years of data. Altria, which if you're those who are not familiar, it was the cigarette tobacco company. I should maybe shouldn't say cigarette. We'll call it tobacco. It sounds a little more refined and sophisticated. It was Philip Morris before it was renamed, which will be familiar to many people. Yes. So, I mean, when we look at those, I mean, what does that contrast teach us about time in the market versus just spectacular annual returns?

15:31Well, first of all, let me just say that, you know, the two stocks you mentioned, NVIDIA and Altria Group, are really remarkable outliers. in terms of the percentage returns that they've delivered for their shareholders. Valtria Group has done it over a longer history than NVIDIA has. So one of the things that was striking to me was that the companies that have the highest cumulative buy and hold returns, and in the case of Valtria Group, I'm going a little bit from memory here, but the number is something like 400 million percent. But it's, you know, it's just one of those numbers you have to sit back and think about.

16:11Now, what exactly is that big number? But it did it with, well, I've got the number right here. It did it with annual returns of 16.5 % over 100 years. So one of the lessons is, you know, we don't really want to say only 16.5%, but 16.5 % over 100 years compounds to something amazing. amazing. So, you know, I think I used the phrase that was only moderately high on an annual basis, but, you know, give it 100 years. Now, NVIDIA, on the other hand, they haven't been listed for nearly as long. NVIDIA has generated 37 % per year. And as you said, that's the highest of any stock that's been there for at least 20 years.

16:58So that's an amazing record as well. But there's no stock that has continued that level of performance for longer horizons. And, you know, I'm not making a call on where NVIDIA is going next. I'm just saying it's not going to deliver. It's very, very unlikely it's going to deliver 37 % per year for the next 25 years. Just history says that those really big numbers just don't persist in the long run.

17:27The Long Term Investor Host:Ian, I'll be sure to link to this in the show notes at the longterminvestor.com. But there is some data that alongside Hank's study, I've always seemed to pair them together. Like what happens in the one year, three years, five years, 10 years before a stock becomes a top 10 stock? And then what happens after that? And it sounds like perhaps some of your research will go into some of this as well. But look, you become the biggest stock in a given market or the world by performing well. And if NVIDIA is around for the next 100 years, obviously Hank and I will not be. But, you know, somebody will be talking about this.

18:03The Long Term Investor Host:If it's compounding for 100 years at a more modest 16 percent as opposed to 37, then yeah. But, you know, I think what you call out is what I tend to believe that the big winners, you know, you can't keep growing at that pace. There is some sort of barrier to that. The other thing that sticks out to me that I referenced earlier is just the case for diversification. I mean, I don't think investors could reasonably expect to identify these huge winners in advance. I mean, is that the main lesson here? It's definitely a lesson. And, you know, you touched on what for most people is probably the biggest question.

18:42They say, OK, wow, you showed us that a few firms are really big winners. Those pull up the overall market. How do I identify those firms? You know, I can, of course, give the flippant answer that if I knew the answer, I wouldn't have to work. But the thing is, it's not easy. You know, lots of people would like to be able to predict those stocks in advance. And, you know, I'm not necessarily one of the high priests of the market efficiency theories. And I use that only slightly tongue in cheek. When I was a younger academic, market efficiency was almost a religion among academics. Anyway, there's a lot of debate about how efficient are the markets.

19:21And, you know, I don't want to necessarily wade into that debate, but it's competitive out there. I mean, if you're if you're trying to identify these big winners in advance, recognize there's a lot of other smart people trying to do it also. So for most people, I really think that my studies just reinforce the desirability of diversification, broad diversification. for everything you've already heard, you know, everything that's in the textbooks. And then on top of that, you know, if you're just picking stocks at random, in a skewed distribution, your odds are not 50-50. If you pick some stocks at random, the odds are against you.

20:02You're probably going to underperform. Now, of course, people will say, but I'm not picking stocks at random. I'm picking the good ones. But now we're back to, yes, so is everybody else trying to pick the good ones. Are you better than the really smart people you're competing against in that endeavor? But that said, you know, there are a few people with the right skill. You know, it's probably just as well that nobody told Warren Buffett he shouldn't try. The problem is, you know, there's more people who think they're the next Warren Buffett than there are people who are actually the next Warren Buffett.

20:40And for the rest of us, how do we tell?

20:44The Long Term Investor Host:Well, and even Warren Buffett himself says if he had to start all over right now today, although he maybe said this a few years ago, like he wouldn't be able to replicate the success because the competition is just so high. You know, for whatever it's worth, I know it's hard for academics to wade in on one side of market efficiency versus not. You academics, you take your debates very seriously, whereas here I am. I'm just an allocator. I can say whatever I want. So I will tell you on a scale of one to 10, with 10 markets being perfectly efficient and one them being perfectly rational, you know, probably like they average like a seven or an eight or something like that.

21:20The Long Term Investor Host:You know, I think in general, markets are really good at pricing things. But occasionally us humans, we get a little crazy. as we think about picking individual stock winners though I think a growing number of investors if you take a little bit of time to educate yourself on your competition as well as just how markets work I think in general people who are watching us or listening to us right now probably in that camp that it's really hard to own individual stocks but they might still do it because it's fun becomes part of identity and maybe you do feel like you have some unique either piece of information or unique way of interpreting the same information that everybody in the world has.

21:58The Long Term Investor Host:But let me ask you this. For investors who own individual stocks, do you think the bigger challenge is finding the winner, holding the winner, or not selling it too early? So I don't have a simple answer for you there. For a few years, I was a consultant to a firm called Bailey Gifford. They're a Scottish investment manager. And they're not a broad diversification firm. They're a narrow, long-term investing firm. And, you know, well, I do think that most people should have diversified portfolios. You know, I don't think absolutely everybody should. I think the capital markets need some investors with conviction, some people that are willing to hold narrow portfolios in the long term.

22:48But one of the things that I tried to work out with them or discussed with them was exactly this issue. You know, they had succeeded in picking some of the firms that have ended up on the leaderboard. And then the question is, well, in real time, do you sell to lock in your gains? Or do you continue to let it ride in the possibility of future appreciation? and there too, it's competitive and there's no easy answers, no simple rule that's going to work reliably. You know, it really just comes down to the, you know, when I teach valuation to my MBA students, I try to convey to people that, you know, the relatively few people who are going to have the right skill, the right comparative advantage are people who can both marry the quantitative models discounted cash flow and other tools with really good intuition about business prospects and growth prospects.

23:50And it really comes down to, you know, using that combination of quantitative tools and intuition to try to ferret out whether the market has fully incorporated in the today's values of this company's long run growth prospects. or have they overshot or have they not yet incorporated it? And, you know, there's not going to ever be any simple way to answer that. But that's the essential issue, the essential question.

24:20The Long Term Investor Host:Yeah, I appreciate that framework. I think of it similarly, you know, like you can have like the intellectual horsepower, but you also have to have some sort of pulse on the psychology of the overall market or the place you're investing. And I started my career as an analyst that researched individual stocks and made stock picks. And when I look at those that did really great, a lot of them were based on a story that I, you know, that I made about the data. Now, the stock might have done really well, but it had nothing to do with the story that I created. And so it's like, you know, and I don't want to get tripped up by compliance by naming names, but I'm going to try this anyways.

25:03The Long Term Investor Host:We'll see if it ends up getting cut out. But like take someone like Monster Energy Drink. I, you know, I was I really felt like that was great for the reason that I thought Anheuser-Busch might buy it. That was really the core thesis of why I like the stock. Turns out Anheuser-Busch got bought. People kept drinking energy drinks. Heck, I had an energy drink right before this. It was not a monster, though. You know, it's one of these things where everyone has to come around to your viewpoint of the world. And then sometimes things turn out in your favor, but not for the reason that you said that it was going to be.