Buy the Winners and Avoid the Losers?

Bloomberg recently published a very interesting article titled: “Lessons of the Century: Most US Stocks Can’t Even Beat a T-Bill.”[1] The article summarized the recent findings of Arizona State University Professor, Hendrik Bessembinder, after he researched nearly 90 years of stock return data including nearly 26,000 US stocks. Professor Bessembinder’s study analyzed the returns for all stocks going back nearly 90 years and compared those returns to the corresponding returns on US Treasury Bills (T-bills). As a quick refresher, T-bills are debt issued by the US government with maturities ranging from a few days up to 52 weeks. They are typically sold at a discount to face value and then redeemed at maturity for face value with the difference between the purchase price and face value considered interest. T-bills are generally considered “risk free” as there is no credit risk and maturities are very short.

The most striking finding in Professor Bessembinder’s study is that 58% of stocks fail to outperform T-bills during their lifespan. This finding is likely surprising to many for several reasons, one being that over the long-term, the returns earned by US stocks collectively have trounced T-bill returns. For example, since 1928, the average annual return for the S&P 500 and 3-month T-bills has been 9.53% and 3.42%, respectively.[2] In other words, stock investors over the long-term have earned over 6% more per year as compared to T-bill investors since 1928. (For you finance nerds out there, this 6% is referred to as the equity risk premium (ERP), or the excess return required to compensate investor for the risks of equity investing). Given the strong long-term outperformance by stocks, it is somewhat surprising that nearly 6 out of 10 stocks fail to beat T-bills.

The article goes on to list several findings from the study:

The average monthly return for US stocks was 1.13% from 1926 to 2015 compared with 0.38% for T-bills,
As mentioned previously, over half of stocks underperformed T-bills during their existence,
Of the 26,000 stocks included in the study, less than 4% (or approximately 1,000) accounted for all of the wealth created, and
Of these 1,000 stocks, 86 generated half of the returns.

It’s pretty remarkable that only 86 stocks are responsible for 50% of all the wealth generated by US stocks since 1926. I always knew there were “outlier” stocks which produced exceptional returns; however, I would have thought that the returns would be more broad-based. The article points out that Exxon Mobil alone accounted for about 3% of the wealth created and Apple accounted for 2%.

The implications from the study are debatable. According to Professor Bessembinder, the results validate the importance of portfolio diversification. If 50% of the wealth generated by stocks over the long-term is due to only 0.33% (86 / 26,000) of stocks, then unless you can find a needle in a haystack, you should probably own a very large number of stocks. This is the only way to ensure that you own and benefit from the big winners. Of course, on the other hand, owning a huge number of stocks guarantees that over half of them will turn out to be losers. And if you could manage to invest a significant amount in one of the big winners, it’s likely that one investment would be sufficient to ensure exceptional long-term performance. Think about those who bought and held onto Berkshire Hathaway stock since the 1970’s and early 1980’s. They are the hundreds of members of the “Berkshire Millionaires Club” today.

Should investors attempt to pick the winners and avoid the losers? Or, should they simply accept the inevitable losers with the knowledge that the winners will make up for it over the long-term? We believe that for the vast majority of investors, diversification makes a lot of sense. It’s fun to dream about finding the next Berkshire Hathaway or McDonalds, but for most, this is impractical and potentially very harmful. Think about it: for everyone who invests a huge sum in a stock and hits the jackpot, there are many more instances where the opposite occurs. Remember, almost 60% of stocks underperform T-bills. Also, remember that the average return to US stocks since 1928 has been 9.53%. That certainly won’t make you rich overnight, but compounded over a lifetime, the results are quite astonishing. Trying to get rich quick in stocks usually has the opposite effect.

[1] https://www.bloomberg.com/news/articles/2017-02-01/lesson-of-the-century-most-u-s-stocks-can-t-even-beat-a-t-bill

[2] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html