By James Saft
(Reuters) - If you want to be a stock picker, you had better be a truly exceptional one because the alternative is not pleasant.
While stock markets in aggregate hugely outperform bonds, especially one-month Treasury bills, the story when it comes to individual stocks is a lot more daunting.
Only 42 percent of stocks, over their entire lifetimes, provide a higher return than one-month Treasuries, and more than half provide negative lifetime returns, according to a new study which looked at U.S. stocks from 1926 to 2015. (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2900447)
You are, in other words, more likely to buy an IPO which underperforms T-bills over its entire publicly traded lifetime than one which beats bills. And these are one-month T-bills we are talking about as a benchmark, an asset which today yields just 0.52 percent annually. This implies the IPO you buy is more likely than not to actually destroy wealth on an inflation-adjusted basis.
But wait, I can hear you say, “I don’t just buy and hold, I know when to trade”.
Well good luck to you, friend, because only 47.7 percent of monthly stock returns are higher than those of Treasury bills.
“The results also help to explain why active strategies, which tend to be poorly diversified, most often underperform,” Hendrik Bessembinder of Arizona State University wrote in a draft study released in January.
That is what you call an understatement.
The study found that the vast majority of all stock market returns come from very few stocks, the big winners which create big fortunes but the hunt for which cause so many investors so much financial misery.
Bessembinder calculated that just 86 stocks have, over 90 years, accounted for $16 trillion in wealth creation, or half the total of wealth created by the entire universe of companies studied over that period.
The other 26,000 or so stocks created the other $16 trillion of wealth, but even that is a misleading guide to how well an individual stock might do.
“The 1,000 top performing stocks, less than 4 percent of the total, account for all of the wealth creation,” according to the study.
“That is, the other 96 percent of stocks that have appeared on (securities return database) collectively generated lifetime dollar returns that only match the one-month Treasury bill.”
WINNER WINNER, CHICKEN DINNER
So when you start picking stocks, you are taking on a hugely asymmetrical risk, with a tiny chance of a great return but a very large chance that you’ll lose ground to inflation. And this is by investing in the asset class which is supposed, by exposing you to future cash flows and the benefits of human ingenuity and productivity gains, to help you beat inflation and build wealth.
Of the top 30 stocks in wealth creation over the 90 years measured, Exxon Mobil (NYSE:XOM) created the most, at $939 billion, and Amazon (NASDAQ:AMZN) had the best monthly return, generating 2.6 percentage points of return above T-bills per month.
To be fair, large-capitalization stocks do better against Treasury bills, with 70 percent of the biggest tenth of all stocks beating bills over a typical decade.
The dominance of larger-cap stocks is underscored by the fact a single stock taken at random and held for a month, replaced in turn by another random stock and so on, is highly likely to underperform. That single-stock strategy underperforms a value-weighted index in 96 percent of simulations and an equal-weight one 99 percent of the time.
The study comes at a good time, given that we are now in a period which many argue will be better for active investors, who’ve been underperforming, at times atrociously. It is true that inflation is coming back, and that various types of risk, particularly political risk, mean that stock returns may become more “dispersed,” meaning that stocks will move up and down all together less but be driven by particular factors more.
A retailer, for example, will be hurt badly by a border tax, if one is imposed by the Trump administration, and banks may be helped a good deal by cuts in regulation.
That’s true, as far as it goes, but the main message of the study is the huge value of diversification. And diversification is cheaper than ever thanks to index funds and ETFs.
So go hunting for tomorrow’s Amazons if you must, but don’t expect a comfortable retirement or a happy meeting with your clients.