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Why picking stocks is only slightly better than playing the lottery

Reprinted courtesy of MarketWatch.com.

To read the original article click here

Investors who think they can be successful stock pickers are about to get some sobering news from new academic research.

The good news: Yes, buying one stock gives you better odds than buying a lottery ticket.

The bad news: Those “better” odds are still much too awful to stake your future on.

For starters, think about Treasurys TMUBMUSD10Y, +3.60% those boring, low-paying government securities that are at least reliable. Right now, you can buy a one-month T-Bill and expect a yield of about three-quarters of 1%. And you’ll get your principal back.

Right now, if you buy some individual stocks at random, you mightget some or all of your money back. And you might make a profit. But at least statistically, your odds will be vastly better with those lowly T-Bills.

I recently learned of a new academic study entitled “Do stocks outperform Treasury Bills?” by Hendrik Bessembinder, a finance professor at Arizona State University. 

The study evaluated every one-month return of every U.S. common stock traded on the New York and American stock exchanges and the Nasdaq NDAQ, +0.97% all since 1926.

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That’s a lot of data: 25,782 distinct stocks (companies, in other words) and 3,524,849 monthly returns from July 1926 through December 2015. (Note to math nerds: The latter number is much less than you would expect, because nearly half of the total stocks went away in less than seven years.)

In the abstract of his study, Bessembinder summarized some of his key findings:

  • The best-performing 4% of listed stocks accounted for the entire lifetime dollar wealth creation of the U.S. stock market since 1926.
  • Only 42.1% of all the stock returns (both monthly and for as long as a stock was listed) were even positive; by definition, the one-month T-Bill rate was always positive.
  • Less than half (specifically 47.7%) of one-month stock returns were greater than the T-Bill returns for the same month.
  • The reason that overall long-term positive stock returns seem so high is statistical: A stock (think Apple, Google, Microsoft) can appreciate by many thousands of percentage points, while a loser like Enron or Washington Mutual can lose only 100%.

So while the stock market DJIA, +0.90% SPX, +0.56%  created about $32 trillion in lifetime wealth over this approximately 90 years, more than half of that came from only 86 top-performing stocks (out of nearly 26,000).

Think you can pick the future winners that well? Good luck!

I agree with Bessembinder that diversification is essential to avoid the 96% probability that any stock you pick today will fail to do even as well as the lowly T-Bill by the end of one month.

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Here’s a quote from his report:

“Not only does diversification reduce the variance of portfolio returns, but non-diversified stock portfolios are subject to the risk that they will fail to include the relatively few stocks that, ex post, generate large cumulative returns. Indeed, the results help to understand why active strategies, which tend to be poorly diversified, most often lead to underperformance. At the same time, the results potentially justify a focus on less diversified portfolios by those investors who particularly value the possibility of ‘lottery-like’ outcomes, despite the knowledge that the poorly-diversified portfolio will more likely underperform.”

In my own words: If you choose your own stocks, you’re very likely to miss the relatively few stocks that turn out to be winners. (Remember, virtually every investor who ever bought an individual stock believed that it would be a winner.) Yet if you want to roll the dice (“lottery-like returns”), the way to do so is simple: Own fewer stocks, not more.

This study is full of other interesting statistics regarding one-year returns and “lifetime” returns, and you may wish to pursue it — however, I must warn you that it’s not always easy going.

Picking individual stocks is essentially a losing game that relies extremely heavily on luck.

James Saft, writing about the study for Reuters, put it this way:

“If you want to be a stock picker, you had better be a truly exceptional one because the alternative is not pleasant. … 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. … This implies the IPO you buy is more likely than not to actually destroy wealth on an inflation-adjusted basis.”

Diversification, on a massive scale, is the right answer for equity investors. Thanks to index funds and ETFs, this is easy and inexpensive to achieve.

This latest study affirms my belief in following academia instead of Wall Street. If this research had been done at Merrill Lynch, do you think it would have had even a slim chance of seeing the light of day? Me neither.

Thousands of hours of work went into this study, and the motive behind it was not to sell anything. The motive was to uncover what really works (and doesn’t work) for real-life investors like us. To me, that spells credibility with a capital “C”.

For more reading, here’s an easy-to-read article about the attractions of index funds.

By the way, I recently visited with John Bogle (he likes to be called Jack, in case you get to meet him), the inventor of index funds. He hadn’t heard about this study, and when I showed it to him he immediately asked his assistant to make a copy for him.

If this information is good enough for Jack, it should be good enough for you and me.

Oh, and if you still think the best route to financial success is by picking stocks, don’t show this article to your spouse.

My recent meeting with Jack Bogle, a true hero to most of us who invest in index funds, was a great thrill. I was surprised by some of the things I learned from him. In my latest podcastI share 10 lessons from “the king of index funds.”

Richard Buck contributed to this article.