Picking Individual Stocks is Stupid
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Returns on stocks are not normally distributed. In other words, the majority of stocks underperform the average return. It is only a tiny number of stocks that drive the entire gain in the stock market over the long run.
The image below depicts the wealth that was created between 1926 and 2019 in the US stock market off the back of. Just 0.32% of companies were responsible for half of the wealth created in the stock market during this time, based off of Hendrik Bessembinder's research.
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Source: Baillie Gifford
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What does this mean for people who are picking individual stocks to invest in?
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Well you better hope you pick these super performers, otherwise your returns are likely to not even exceed Government bonds. Hendrek Bessembinder published a study called "Do Stocks Outperform Treasury Bills?" in 2017. He found that only 4% of stocks were responsible for the total amount of wealth generated by the stock market between 1926 and 2016, with 96% of stocks only able to match the gains of one-month US treasury bills.
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The five top performers during this period were Exxon Mobile, Apple, Microsoft, General Electric and International Business Machines. They accounted for a whopping 10% of the wealth created during this period!
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Hendrek Bessembinder published another study in 2019 called "Do Global Stocks Outperform US Treasury Bills". In this study he looked at the returns of 62,000 international stocks from 1990 to 2018. To no surprise he found again that only a minority of stocks was responsible for the total wealth creation. In this case, 811 firms (1.33% of stocks) accounted for all of the net global wealth creation.
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This helps to explain why actively managed funds frequently underperform the average market return. The reason for this is because they are often too concentrated (not diversified enough) and do not include all of these minority stocks that generate these freakishly high returns.
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The image below depicts the S&P 500 individual stocks returns over a 20 years period (1997-2017), which also helps to visualise the positively skewed nature of stock market returns for individual companies. A positive skew is simply where the distribution of most values is clustered around the left tail of the distribution, while the right tail of the distribution is longer.
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The median (middle number in a dataset) return during this period was 50% which is a mere 2% annual return. This means that half of the stocks during this period returned 2% a year or less, with 30% of stocks actually losing value. The reason that the median return is so much lower than the average return, which was 228% (6.1% annual return) is because the drastic returns by the upper echelons of the market are able to drag it upwards.
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S&P 500 Individual Stock Returns 1997-2017
Source: S&P Dow Jones Indices LLC, FactSet. Data from 12/31/97 to 12/29/17
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It could be argued that a professional investor can identify the super performers through their own analysis, subsequently enabling them to beat the average market return. Unfortunately, the chances of this happening are extremely low because it is ultimately impossible to predict the future. In addition, there are a number of other hinderances such as trading fees, which eat into an actively managed portfolio's returns.
This was proven through Warren Buffet's $1 million dollar bet with hedge funds. You can learn more about Buffet's bet with the hedge funds by viewing my blog post about why actively managed funds suck by clicking here.
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Below shows a representation of the top 20 performers in the S&P 500 over a 10 year period from 2009 to 2019. How many of these companies would you have guessed would have had meteoric growth during this period?
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Source: Visual Capitalist
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It is clear from the research presented above that trying to identify this minority of companies that produce extraordinary returns is very much like trying to find a needle in a haystack. The solution to this is just to buy a global index fund that is guaranteed to have the super performers included.
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"Don't look for the needle in the haystack, just buy the haystack!" - John Bogle