If you have been paying attention, you know how much we believe in equity markets. Our clients who have a long enough time horizon and the risk tolerance to endure bear markets are invested, at least to some degree, in massively diversified portfolios of stocks.
A reason we recommend portfolio diversification is because most individual stocks lose money, even when the market is performing well.
Why Compounded Stock Market Returns are Misleading
Since 1926, the S&P 500 annually compounded return has been 10% per year. This makes the US stock market the greatest generator of wealth in human history. There is no other form of investment that even comes close.
Yet during that same time period (1926-today), most US publicly traded common stocks have lifetime returns of less than 3.3%, which was the rate of return on 1-month Treasury Bills. That is only .4% better than inflation over that time period! In fact, most individual stocks lose money. The average stock exists in major indexes for just seven years, and the most common outcome is a total loss.
How can the market perform so well while specific stocks perform so poorly? It turns out that the net gain for the entire U.S. stock market since 1926 is attributable to only the best performing 4% of the listed companies.
Let that sink in a bit and consider the ramifications: Any stock chosen at random has only a one in twenty-five chance of being in the group of higher performers. There is a 96% chance that any stock you pick will have below-average long- term performance. Just one in 25 stocks is worth owning for the long term compared to basic Treasury Bills.
What is happening is that a small handful of stocks deliver such impressive performance that it brings the entire average up a great deal. Of course, we can’t just pick the few stocks that have done well in the past and expect those same stocks to be high performers in the future. If history is any guide, there is only a very small chance that they will continue to be in the group of high performers.
This helps explain why stock picking or predictive approaches most often under-perform market averages, and it highlights the advantages of indexing. Using this information, an even better strategy would be to hold even more names than the indexes. Casting a wider net through massive diversification is the most assured way to own those high performers, thereby increasing your odds of matching or beating the market averages.
1 Dimensional Matrix Book 2019
2 Bessembinder, Hendrik (Hank), Do Stocks Outperform Treasury Bills? (May 28, 2018) Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/absract-2900447