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STOCK MARKET Investing requires a near superhuman ability to withstand pain. That’s the conclusion of a recent report by investment researcher Michael Mauboussin.
Mauboussin surveyed all stocks trading on U.S. exchanges over a 40-year period, between 1985 and 2024. He found that the median stock experienced a decline of 85% at one point or another. Worse yet, more than half of these stocks never fully recouped their losses. The median stock recovered to just 90% of its prior high-water mark. Among those stocks that were able to reclaim their prior highs, it was a long process—about five years, on average. This would have tried any investor’s patience.
Those numbers only apply to the median stock, but suppose you had above-average stock-picking skills. How would things have turned out? If you had the foresight to pick the 20 best performing stocks over that 40-year period, they still would have delivered an agonizing drawdown of 72%, on average.
It’s hard to remember, but Apple dropped 83% at one point. Nike once lost 66%. Even Nvidia, which was the best performing stock over the past 20 years through 2024, lost more than 90% at one point. And most notably, Amazon was once down 95% from its prior high.
It’s known that the stock market is unpredictable, but these numbers provide additional insight into the market’s dynamics.
In general, the stock market is rational. Over the long term, share prices do move in tandem with corporate profits. When a company’s earnings increase, often its share price does too. The problem is that prices are only sometimes rational. Very often, stock prices disconnect from corporate earnings, and the gap can be significant. This was first proven empirically in the 1970s by Daniel Kahneman and his longtime collaborator, Amos Tversky.
In 1974, they published a paper titled “Judgment under Uncertainty: Heuristics and Biases.” It was one of the first papers in the nascent field of behavioral finance, and what they found was that investors exhibit an “availability heuristic.” That is, they tend to rely on the information that is most available. That’s a problem because the information that happens to be most available isn’t necessarily the information that’s the most accurate or even relevant. Often, the information that happens to come to mind is, as Kahneman and Tversky put it, the information that’s most vivid. In other words, extreme information or news becomes most memorable, and thus drives decision-making.
Later research built on this idea. In the mid-1980s, economists Werner De Bondt and Richard Thaler published a paper titled “Does the Stock Market Overreact?” They found that share prices definitely do overreact. A casual observer might find that conclusion intuitive, but De Bondt and Thaler were able to prove and quantify it. They looked at stocks that had either outperformed or underperformed by a significant margin in recent years, then examined their performance over subsequent years.
They found that stocks exhibiting extreme performance tended to reverse course. Strong performers lagged, and weak stocks often outperformed. The implication: Investors systematically overreact to news, driving stocks too far in one direction or the other.
It’s for these reasons Warren Buffett scolded investors for their short-term thinking. During the market slump earlier this year, Buffett commented, “If it makes a difference to you whether your stocks are down 15% or not, you need to get a somewhat different investment philosophy,” adding that, “People have emotions, but you got to check them at the door when you invest.”
On this point, Buffett’s late partner, Charlie Munger, was more blunt. “If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century,” Munger said, “you’re not fit to be a common shareholder.…”
In making these comments, Buffett and Munger weren’t being preachy; they knew from decades of experience what De Bondt and Thaler’s research concluded—that the market is often irrational, and it can irrationally punish even the best of companies’ stocks. About 10 years ago, Buffett noted that Berkshire Hathaway—his own company—had seen its stock drop 50% on three separate occasions. “Someday, something close to this kind of drop will happen again, and no one knows when,” he added.
What complicates the equation is that the stock market sometimes makes an extreme move that’s justified and not the product of emotional overreaction. In January, for example, when Nvidia shares dropped 17% in a single day, it was in response to a potentially serious competitive threat. Similarly, Apple shares are down about 14% this year in response to some real concerns, including slowing iPhone sales, a weak position in AI and the impact of tariffs. Similarly, Alphabet—parent company of Google—has seen its stock underperform this year as AI tools like ChatGPT chip away at its market share.
Of course, no one knows where any of these stocks will go next. Whether it’s in response to tangible news, emotional overreaction, or some combination of the two, stock price movements will always be unpredictable. That’s a reality, but there is a way to mitigate it.
As noted earlier, Mauboussin found that the median stock suffered a drawdown of 85%, and even the best stocks saw a drawdown of 72%. But the S&P 500, a broad market index, never experienced a drop of that magnitude during the time period studied. The worst drop experienced by the S&P was 58%—terrible but far less bad than the experience of those individual stocks. I believe this is a key reason to avoid picking stocks and instead to invest using index funds.
In addition to managing risk, index funds offer another powerful benefit. As noted earlier, the median stock in Mauboussin’s study never fully recovered after experiencing a decline. But on average, stocks definitely do recover and significantly surpass their prior high-water marks. On average, stocks gained nearly 340% when they bounced back.
Why the distinction between the median and the average? It’s a technical point but an important one. The results for the median stock are unaffected by the performance of outliers. But outliers are the main driver of the market’s overall return. When a stock like Nvidia gains 86,000%, as it has over the past 20 years, that pulls up the average. While an investor who was exceptionally forward-looking, bordering on clairvoyant, might have purchased Nvidia shares—and held onto them—over the past 20 years, most wouldn’t have been that fortunate. Over the years, however, the S&P 500 has owned Nvidia, along with Apple, Amazon and the market’s other big gainers, helping the index to notch healthy gains.
The bottom line: Picking stocks can be entertaining. But according to the data, it’s not the most reliable way to build wealth. What’s the best way? Index funds. Why? They cast a wide net and are unaffected by emotion, allowing investors to benefit from the growth of exceptional stocks while simultaneously limiting the impact of drawdowns.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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The eternal fight, between two groups of competing theorists, between two groups of investors, and between two groups of researching academics: Is the market efficient, or is it emotional with lots of momentum? The answer is “Yes”.
Let’s stick to KISS (Keep It Simple Stupid). I wish I had someone in 1976 when I graduated college tell me to invest in this new investor friendly fund called the Vanguard S&P 500 Index Fund created by John Bogle. You are all probably aware of this quote from Mr. Bogle – “Don’t look for the needle in the haystack. Just buy the haystack!” Keep investing on a regular basis, have the fortitude to not panic when the market declines and sleep well.
Adam,
When you say, “What’s the best way? Index funds,” I think it’s important to clarify what kind of index fund you mean. These days, nearly everything has an index—even very narrow or specialized sectors. There are index funds for tech, crypto, emerging markets, ESG themes, and even leveraged strategies.
So just saying “index funds” doesn’t quite mean what it used to. A few years ago, it usually referred to low-cost, broad-market funds like the S&P 500 or total stock market funds. Now, someone could be in an “index fund” that’s far riskier or more concentrated than they realize.
I still believe in the power of simple, diversified index investing—but it’s worth helping people distinguish between broad-market, low-cost index funds and the new breed of niche or thematic ones that carry very different risk profiles.
Do you agree?
same sentiment here.
Definition of “index funds” deserves a separate article. Not all indexes are created equal: S&P 500 (cap-weighted), Nasdaq 100 (tech focus), MSCI EAFE (international), CRSP (total market), Russell 2000 (small cap), Fidelity Zero Fund index (proprietary). Fund providers use jargons that sell: index, “smart beta”, AI-powered, direct indexing, ESG – obscuring basic principles sometimes.
I love indexes but it doesn’t mean it’s the only game.
A good friend of mine invested $3K each in 10 companies in 1991. Then he added to his 401K every month to the SP500.
9 stocks were average at best MSFT made him at least 1.5 million. He never sold a share. He just followed Buffett’s advice.
Conclusions: you can do both.
I have a “hybrid” portfolio comprised of individual stocks and ETFs. I don’t own a S&P 500 index because I refuse to own the stock of certain companies, or purchase their products. One of the beauties of owning a “wrapper” like an index is one can be oblivious to how or where, or under what conditions companies actually make their money. The point of owning an index is to be insulated in many ways.
My approach is more difficult, but I can honestly say that over 30+ years I have learned a lot about certain firms, their management and processes. Oh, and I’ve done much better since 1995 than the S&P 500. It isn’t for everyone. (My records were sketchy prior to 1995 and my holdings slight, but for decades I’ve kept meticulous records. This is automated ).
I’d say the first 10 years of that 30 year period were a learning experience. Prior to that I simply “dabbled”. Prior to the Dot-Com bust I’d say my mental state was “oblivious”. I followed the experts. After the bust I developed awareness and a long-term mindset, made certain decisions about the nature of investing and became a significantly better investor.
Oh, and I am a long term investor. I won’t buy anything (individual stock or ETF) unless I intend to own for at least 5 years. Most of my holdings have been “held” for about 20 years, but if a company fails my original thesis for buying it is sold. So too for those with overly politically active management. I expect management to increase shareholder value. Holding for short periods isn’t investing. It is trading. Few people are equipped to be good traders. Yet; they are inclined to sell at the slightest doubt.
Investing via an index isn’t a formula for instant success, either. The expression is “time in the market beats timing the market.” If one can’t tolerate volatility or market or political uncertainty then CDs might be a better choice.
Let me explain why picking stocks is the most reliable way to build wealth.
If you analyze companies, you understand their business model, products, revenues, profits, cash flow. You know what you own, and what it is probably worth as a company.
Now suppose there is a giant stock market crash – 2008-9 is a good example. Like the rest of the market, stocks like Con Ed, Verizon, and Chevron plummeted. If you owned these stocks, did you think the financial crash was going to cause people to stock using electricity, making phone calls, and driving cars? The answer to this question should give you the courage to stick to your guns, and buy more shares if you had the cash.
But if you are an index investor, you don’t really know what the 500 companies in the index do, and what they are worth. You are much more likely to panic and sell.
Thanks for anorther nice article, Adam. In indexing we trust! For those like to play and seek more excitment, I will advocate no more than 5% of the portfolio as fun money for stock picking, etc.
Those big drops are the time to buy (stocks on sale). Portfolio diversity is the way to plan for large drops. It’s very rare that everything is down at the same time. Even with index funds you need to diversify to funds that cover different market sectors and countries.
It’s a great article. I have to admit I have such trouble following it. I’ve done well in the market but have such a terrible desire to endlessly tinker with my portfolio with narrow focused EFT’s trying to beat the market. It’s a fool’s journey.
Rather than remembering the vivid stories that describe the extremes of market performance, I hope my thoughts dwell on an article such this one, that highlight the wealth-building power of index funds. Great job, Adam!
Adam is right: holding the index is a safer bet than stock-picking for the bulk of a portfolio. But at times even the index reaches crazy highs (and lows).
So Patrick’s point below is also noteworthy.
Ignoring the brief tariff tantrum in April, the S&P 500 closed Friday up ~78% off its low of 12 October 2022. Over the past 125 years, the U.S. stock market has grown at a real rate of 6.8%/year after inflation. At that rate off the recent low, the index should be a lot lower. None of that matters if your financial plan is built to withstand big market declines.
6.8% real gain is astounding isn’t it.
Yes indeed. Have to ride the roller coaster to earn those over time.
Adam, good article and thanks to the link for the research paper.
Great article Adam. With the stock market bouncing off all time highs, keeping a potential drawdown in perspective is very important. During times like this it’s easy to feel like a genius, however, Mr. Market often has a surprise in mind.
An article only a student of the stock market could love.
and index fund investors:)