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Last updateTue, 12 Dec 2017 4pm

Business & Real Estate

Picking winning stocks can be a losing strategy

Here’s a simple question: Which has had better historical returns, stocks or one-month U.S. Treasury bills?

The answer is pretty much of a no-brainer. Since 1926, Treasury bills have returned a paltry 3.5 percent annually on average, versus more than 10 percent for the Standard & Poor’s 500 index. But that’s the average return for all large-company stocks.

What about individual stocks? Hendrik Bessembinder of Arizona State University – in a working paper titled “Do Stocks Outperform Treasury Bills?” – found that 58 percent of common stocks have returns over their full lifetimes less than that of one-month Treasuries. Even more astounding: More than half of all stocks have negative lifetime returns.

How can this be possible? To understand it, we must first start with the statistical concept of a normal distribution. You may recall that it looks like a bell curve when displayed graphically. And it’s symmetrical, which means the average of all of the data points is identical to the median. (The median is the point at which exactly half of the data points are above and half are below.)

Modern Portfolio Theory, the Nobel Prize-winning theory that underpins most professional investment methodologies today, assumes that stock returns over time are normally distributed. But Bessembinder found that there is significant positive skewness in the contribution of individual stock returns to aggregate average U.S. stock market performance. That means there are always some stocks that proportionately contribute much higher returns than the average.

How many are there? After studying the performance of the 26,000 stocks that have come and gone since 1926 – which collectively have been responsible for lifetime shareholder wealth creation of nearly $32 trillion – Bessembinder discovered that just 86 stocks accounted for more than half of the total market return over the past 90 years. And only 1,000 (less than 4 percent of the total) accounted for all of it. In other words, the entire gain in the U.S. stock market since 1926 was attributable to the best-performing 4 percent of listed stocks.

Working the odds

You might conclude from Bessembinder’s study that stock picking can be extremely lucrative. If you can pick the right ones, you’ll make a killing in the market. But if you pick the wrong ones, you’ll do worse than if you had just purchased U.S. Treasuries or bank CDs. And besides the fact that the winning stocks keep changing over time, the odds of consistently picking them – because there are so many more losing stocks than winning stocks – are phenomenally low. Even gambling odds in Las Vegas are better than that.

Bessembinder’s work has poked some holes in the key theory that has been the mainstay of the financial planning profession for decades. So knowing this, should you now avoid the stock market entirely? Not if you want to participate in that $32 trillion of wealth generation.

The findings do suggest avoiding actively managed funds that are based on selective stock picking, because you should expect them to underperform market indexes over time (unless the fund manager happens to be clairvoyant). But you can still buy some kind of market index fund that invests in the entire market or sector. You may end up holding a lot of losers, but you’d be guaranteed to be holding the winners as well, and they’ll be the ones to put you over the top.

To read the study, visit papers.ssrn.com/sol3/papers.cfm?abstract_id=2900447.

Los Altos resident Artie Green is a Certified Financial Planner and principal at Cognizant Wealth Advisors. For more information, call 209-4062, email This email address is being protected from spambots. You need JavaScript enabled to view it. or visit cognizantwealth.com.

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