Why You Don’t Have to Pick Winning Stocks (EP.166)

0:28We all need to make smart decisions with our money. be anything more seductive than picking a winning stock. And not just any stock that goes up, but one that doubles time and again. In my opinion, one of the reasons people buy individual stocks is the dream of finding that stock, that perpetually doubling stock, and the psychology around it is somewhat similar to the psychology of buying lottery tickets. The dangerous difference though, is that people know they're going to lose when they buy a lottery ticket. Stocks, on the other hand, provide a far greater sense of control over our own destiny, which unfortunately is simply an illusion and one that the financial media and even the brokerage apps and websites seek to enforce.

1:18In reality, investing in individual stocks is quite risky and, as I'll explain in this episode, not even necessary. Let's start with the history of individual stock returns. There are numerous studies providing compelling evidence that the majority of individual stocks fail to outperform the broader market and even risk-free assets like treasuries. One notable example is from Hendrik Bessenbinder titled, Do Stocks Outperform Treasury Bills? In this paper, Bessenbinder analyzes the total returns of U.S. common stocks from 1926 to 2016 in which he finds that the median stock generated a return of negative 3.66 % per year, and only 42.6 % of individual stocks had lifetime returns that exceeded those of one-month treasury bills.

2:17Meanwhile, the top 4 % of stocks accounted for all the net wealth creation during that period, with only 90 companies, and that's 90 companies out of 25 ,967 companies in the sample. Just 90 companies, or 0.33%, accounted for more than half of the return. A more recent example of this type of research comes from J.P. Morgan's Agony and Ecstasy, which finds that 66 % of all individual stocks trailed the Russell 3000 from 1980 through 2020. Other research from Goldman Sachs, dating from 1986 to 2022, showed that 36 % of Russell 3000 in stocks suffered a permanent impairment, which was defined as a stock that loses more than 75 % of its value and does not recover to 50 % of its original value.

3:17All of these findings highlight the risks of relying on individual stocks. There's also significant skewness in the returns such that the likelihood of any given individual stock beating the market is quite low. Now, if this doesn't resonate with you, then let's consider the performance of professional stock pickers. Since first published in 2002, the S &P Indices vs. Active, or SPIVA, scorecard has served as a de facto measure of the effectiveness of active management versus indexing. The SPIVA scorecard is released twice a year, and I have the most recent version linked in the show notes at thelongterminvestor.com, and it shows that 79 % of all U.S.

4:07equity funds trailed their respective benchmarks over the last three-year period, 85 % failed over the last five years, and more than 91 % failed over the last 10, 15, and 20-year periods. And if we look at the global, international, and emerging market funds, they didn't fare much better. They also failed to beat their benchmark quite frequently, ranging anywhere between 70 % and 90 % of the time, depending on what time period we're measuring. These results are not specific to this most recent report or any point in history. You can actually Google past years of the SPIVA report and find similar results.

4:49Now, obviously, the numbers vary a bit year to year, but the one trend that seems to always stay intact is that the underperformance rates rise as the time period being measured lengthens. So here's what we know thus far. One, individual stocks are very risky, and the probability that you can even match the overall market's return by buying individual stocks is low. In fact, there's quite a bit of data that shows that you might struggle just to beat treasury bills. The second thing we know is that professional investors running actively managed mutual funds and ETFs, they struggle with security selection too.

5:34They have enormous failure rates in trying to just buy stocks in a manner that beat the underlying index. Here is the good news. You don't have to pick winning stocks to earn the returns you need to reach your goals. That's because diversified investors always own the winners. There is a new paper by Hendrick Bessenbinder that's been making the rounds and identifies the highest long-term returns among common stocks dating back to December 1925. And since hitting it big on an individual stock is the ultimate investor pipe dream, I put a table from the paper in the show notes at thelongterminvestor.com that highlights those common stocks with the highest cumulative returns.

6:23And most investors will recognize many, if not all, of the best-performing companies because they are largely what would be considered blue-chip stocks today. But while this table is interesting to look at, perhaps the most shocking result in the paper is the difference between the mean, or the average, cumulative return and the median, which is that midpoint cumulative return. And when you go back to 1926, the average cumulative return on an individual stock was just under 23 ,000%. Now, going back to 1926, that's about 100 years, and this is a cumulative return that is compounding. So trust me when I say 23 ,000 sounds like a big number, but over that long a period, it really isn't.

7:10Here's where actually the shocking point. So that's the average. if I just take the median, which is the midpoint of the entire sample, the cumulative return was negative 7.41%. Again, that's that skew that I was talking about earlier, where the probability of picking a winning stock is so much harder than people realize. But again, the good news is that if you're broadly diversified and own something like the total US stock market index, You own and benefit from any given stock that delivers outsized returns. Proponents of diversification, including myself, often will highlight the benefits of diversification, such as preventing a catastrophic loss in one investment that materially impacts your portfolio.

7:59But the other benefit of broad diversification, particularly when you own the entire market, is that you effectively know that you will not miss out on the winners. And look at any of the largest companies in the U.S. right now. If you're holding a total U.S. stock market index fund right now, you own a meaningful weight in these companies. For example, as of this recording, owning the total U.S. market means holding over 6 % in Apple and just under 6 % in Microsoft. If we look at the weightings of the other top 10 companies, they're ranging between 1 % and 5%. Now, if you're globally diversified, as I think you should be, then a market cap weighted index approach still gives you nearly a 4 % weighting in each Apple and Microsoft.

8:53And when you look at the other top 10 companies' weightings, they fall anywhere between 0.8 % and 3.25 % each. And in both of these circumstances, US versus global, those are not insignificant weights and they leave you well positioned to benefit should those companies continue to deliver outsized gains that made them the largest companies in the first place. And again, these are just the biggest companies. I have included a table in the show notes at thelongterminvestor.com of the top performing stocks over the last 10 years, and many of them are not mega cap household names. And there's also a link to the source of this chart, which shows you the best performing stocks over the last five years, over the last one year.

9:40And I think you will notice that they are not common names that you would naturally be aware of. So let me repeat an important statistic from earlier in the episode. The top 4 % of stocks accounted for all of the net wealth creation going back to 1926. And only 90 companies, or 0.33 % of stocks, accounted for more than half of the return. So if we know that only a small fraction of companies make up the vast majority of wealth creation in the stock market, you should be less concerned about winning the low probability game of picking those winners in advance and be more concerned with positioning yourself to own the winners no matter what.

10:27So why do we buy individual stocks in the first place? I think for most people it's a number of things. It's more tangible. It's fun and exciting. It gives us the feeling of control. It can be this form of self-expression and it can also just be the result of FOMO because winning investments always find their way to the center of attention. And I also think there's this piece where investing is so highly quantifiable that it leads us to believe that there is always an objectively optimal decision out there. And if we just spend enough time thinking or researching or looking will find it. And this is largely an illusion.

11:09There is no perfect portfolio because we can't know in advance what investments we'll win over any given time period. And if we kick ourselves for missing an obvious opportunity, it's probably because we conveniently forget that it is only obvious after the fact. Look, individual stocks are much riskier than you think. Not only that, but picking winners is so difficult that even professional investors whose explicit objective is to do that consistently, they too fail to meet their objective. And when you boil it down to its simplest first principle level, the purpose of investing is to grow your wealth at a rate that is greater than inflation without taking undue risk.

11:57So the next time that you're tempted to invest in individual stock or feel like you missed out on outsized gains, remember that if you were a diversified investor, one, you probably didn't miss out because you had some exposure. And two, you did so by minimizing the chances of making an unnecessary mistake. Again, lots of resources, lots of links in the show notes today at thelongterminvestor.com. Be sure to visit there when you get a chance. And be sure to subscribe if you find this information helpful. And feel free to forward to a friend if you think they might too. Thanks as always for listening.

12:37And until next time, to long-term investing. Thanks for listening to the Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.