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:
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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Instead of picking the top X% of stocks by whatever your criteria (that might be a winning strategy), would it not be surer to leave out the bottom X% of stocks on the exchange (or Nasdaq 1000 or S&P500 or whatever) and settle for that return and that security to sleep at night? (asking for a friend)
If a simple strategy like that worked, professional money managers would be all over it. Some of the stock market’s best wealth creators have turned out to be stocks that were wretched long-term performers, but happened to pay handsome dividends before they got into financial difficulty.