Allure of the Game

Are You A Stock Guru?

So, think you can outperform the market? Do you keep up-to-date on all the latest news, trends, analyst reports, and financial statements? Know what’s up-and-coming and what’ll go bust?


If so, you’re like the many of us out there that dabble in individual stock selection. That’s right, myself included. If you haven’t already, check out My Portfolio to see the atrocities I’ve committed in the face of the broad-based index fund gods.


If you too are sitting there with a hefty sum of individual stocks in your portfolio, boy do I have some bad news...


Hendrik Bessembinder


It turns out that, as individual stock owners, the odds are incredibly stacked against us. In a 2017 academic paper titled “Do Stocks Outperform Treasury Bills,” Hendrik Bessembinder of Arizona State University tells it like it is.


Using data from the Center for Research in Securities Prices (CRSP), Bessembinder finds that “Of all monthly common stock returns contained in the CRSP database from 1926 to 2016, only 47.8% are larger than the one-month Treasury rate in the same month.”


That’s right. Less than half of all individual stocks over the last century have beaten the returns of the safest investment you could imagine—U.S. Treasury bills. In fact, the majority of returns were actually negative! Ouch.


It Gets Worse

“Okay,” you may be thinking. “That’s not so bad. If I can at least select the proper half of stocks, I’ll outperform the market!” Nope. The 47.8% of stocks referenced above were only able to beat U.S. Treasury bills. Not the market!


Bessembinder continues by pointing out how relatively few stocks actually contribute to overall market gains. This is where things get really crazy.


Of the $35 trillion generated wealth since 1926, Bessembinder points out that “Five firms (Exxon Mobile, Apple, Microsoft, General Electric, and International Business Machines) account for ten percent of the total wealth creation. The ninety top-performing companies... collectively account for over half of the wealth creation. The 1,092 top-performing companies, slightly more than four percent of the total, account for all of the net wealth creation.”


You read correctly. Only 4% of all companies listed on the CRSP database account for all of the generated net wealth over the last century. All other companies combined simply matched the returns of one-month Treasury bills. Selecting the correct half of the market is one thing—but the correct 4%?! That sounds… difficult.


Timing


So, at this point I’m fairly convinced that individual stock selection is a losing game. But what about timing the market? Buy low, sell high. That has to be possible, right?


Nope. Bessembinder doesn’t stop there. His next point refutes the premise upon which many investors think they can time the market.


Quoting numerous studies, Bessembinder writes “Savor and Wilson (2013) show that approximately sixty percent of the cumulative stock market excess return accrues on the relatively few days where macroeconomic announcements are made. Related, Lucca and Moench (2016) show that half of the excess return in U.S. markets since 1980 accrues on the day before Federal Reserve Open Market Committee (FOMC) meetings.”


In other words, the majority of stock market gains are made on relatively few days of the year. Are you confident enough to guess those days? If so, great. If not, you may miss out big on the most positive day of the year!


The Lesson


Many people, myself included, are not immune to the allure of crazy high returns through individual stock selection and market timing. If it’s an itch you have to scratch, just know the odds are stacked against you.


Bessembinder is not blind to the allure either, for he writes “The results potentially justify the selection of less diversified portfolios by those investors who strongly value skewness, i.e., the possibility of large positive outcomes, despite the knowledge that a typical undiversified portfolio is more likely to underperform the overall market.”


In other words, there is something to be said for individual stock selection and market timing—if your goal is more akin to gambling.


But if you are looking to ride the market long-term until retirement, you can’t beat the simplicity and diversification of broad-based index funds. Jeez. Is that really the lesson again? Yes. Yes it is. This way, you’ll never miss out on the next 4% of stocks that drive the market.


Happy investing.

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