Odds Against

IF YOU WANT TO BEAT the market, you need to pick stocks that perform well enough to overcome the investment costs you incur. That task is made harder not only by the market’s efficiency, but also by another hurdle: skewness.

What’s that? The most a stock can lose is 100% of its value, but the possible gain is far greater than 100% and potentially infinite (though no stock has got there yet). In any given year, the market’s highest-flying stocks—which might double or triple in value—skew the market averages upward, so most stocks end up lagging behind the averages.

Investors have long been aware of this phenomenon, but a recent academic paper took the notion—and added a huge exclamation mark. Hendrik Bessembinder, a finance professor at Arizona State University, looked at U.S. stock performance over the 90 years through December 2015. Here’s what he found:

• Over their lifetime, 58% of stocks underperformed one-month Treasury bills and a majority lost money. For purposes of the study, lifetime was measured from 1926 or whenever a stock was listed through to 2015 or whenever a company was delisted.
• The 25,782 stocks that existed during these nine decades managed to create some $32 trillion of value for shareholders, over and above what they could have earned in T-bills. But the top 86 stocks accounted for half that wealth.
• The largest wealth creator was Exxon Mobil, at $940 billion. Other major contributors were Apple, General Electric, Microsoft, IBM, Altria Group, General Motors, Johnson & Johnson, Wal-Mart Stores and Procter & Gamble. Most of these stocks performed well. But their large contribution to wealth creation also reflected both their size and corporate longevity.
• Over the 90 years, the U.S. stock market’s entire gain, over and above T-bills, can be attributed to less than 4% of stocks. The other 96% collectively matched T-bills.
• Smaller-company stocks were especially likely to lose money—not a huge surprise. More surprising: Higher returns were clocked by companies with little or no debt. (This latter insight reflects performance since 1962—the period for which data on leverage was available.)
• The typical stock was around for only seven of the 90 years. In fact, of the 25,782 stocks, just 36 were in existence for the full nine decades.

Skewness is a powerful argument for broad diversification, especially through total market index funds. That way, you don’t run the risk of badly trailing the market. But instead of appreciating that powerful argument, many investors are drawn to the sizzling sideshow.

What sideshow? While skewness means most stocks and most active managers will end up with market-lagging results, that still leaves a modest number of winners—and their triumph can be spectacular. The danger: Inspired by those big winners, many investors will stray from more diversified strategies, and try their hand at picking hot stocks and star managers. Most, of course, will pay dearly for their greed—thanks to skewness.

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