Anything but Average
Adam M. Grossman | May 4, 2018
SHOULD YOU invest in the stock market? The answer seems obvious: Over the past 90 years, stocks have returned an average 10% a year, far outpacing bonds at 5% and cash investments at less than 3%.
So why ask the question? The reason is the word “average.” Stock market returns are, of course, uneven from year to year and uneven from stock to stock. That’s well known. But the degree to which stock performance varies from stock to stock may surprise you—and that has implications for how you invest. Arizona State University professor Hendrik Bessembinder provided these unexpected insights in a recent paper entitled “Do Stocks Outperform Treasury Bills?”
- Between 1926 and 2016, just 4% of all stocks accounted for all of the net gains in the U.S. market. All other stocks, as a group, delivered returns that were no better than Treasury bills.
- Over that same time period, more than half of all stocks would have delivered a negative return to a buy-and-hold shareholder. In fact, the single most common return was -100%—in other words, a complete loss.
- Treasury bills have historically returned just 2% a year. And yet, for any given stock in any given month, the odds of beating Treasury bills were slightly worse than even: T-bills beat individual stocks 52% of the time.
What should you conclude from this? Am I saying you shouldn’t invest in the stock market? No, I still view stocks as the best way to increase your wealth over time. But I see three important implications:
- Diversification is even more vital than you might have guessed. Since market gains are so skewed toward a small number of stocks, it’s critical that you own those winners—companies like Apple, Amazon and Biogen that have grown exponentially over the years. Amazon’s stock, for example, has climbed 20-fold over the past 10 years and more than 200-fold over the past 20 years. Problem is, it’s very hard to separate the future Amazons from the future Enrons, so your best bet is to own broadly-diversified index funds, which will give you a slice of every company, ensuring you own the extreme outperformers.
- While the S&P 500 is a great starting point for any portfolio, you shouldn’t stop there. When you buy index funds, make sure you include mid-cap and small-cap holdings, which are where the future Apples and Amazons may be found today.
- I don’t recommend buying individual stocks, but Prof. Bessembinder’s study does provide an important caveat: If you are able to identify a future winner, it could make all the difference. In fact, as I have pointed out in the past, most of the world’s great fortunes—Gates, Carnegie, Rockefeller and the like—came from single stock holdings.
If your field of expertise provides you with unusual insight in a particular area, you might be in a position to spot a future Medtronic, Biogen or Qualcomm when they’re just getting started. The good news: If you identify a potential stock-market superstar, you can still keep the bulk of your portfolio broadly diversified—because there’s no need to invest a lot. For example, in 1997, if you had invested just $1,000 in Amazon, you’d have $1 million today.
Adam M. Grossman’s previous blogs include Protect Your Privacy, Losing It and Plan, Prioritize, Proceed. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.