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BAM Intelligence

More Hazards of Individual Stocks

In a recent article that highlighted the perils of owning individual stocks, I offered the historical evidence demonstrating how only a small percentage of stocks have accounted for all the gains provided by the market—with the vast majority earning a big, fat zero in aggregate cumulative returns, even before considering the impact of inflation or taxes.

The article included a study by Longboard Asset Management called “The Capitalism Distribution,” which covered the period 1983 through 2006. Longboard recently updated the study, so I thought I would share its findings, which serve to reinforce the risky nature of owning individual stocks.

The new study covers the period 1989 through 2015 and a total of 14,500 stocks. Over this period, the S&P 500 Index returned 10.0% and provided a cumulative return of 1,324%. The broader Russell 3000 Index produced almost identical results. It returned 10.1% per year and provided a cumulative return of 1,341%.

Key Findings

The following are some of the study’s important findings—findings that demonstrate just how risky investing in individual stocks, and a failure to diversify, really is:

  • 1,120 stocks (7.7% of all active stocks) outperformed the S&P 500 Index by at least 500% during their lifetimes.
  • 976 stocks (6.8% of all active stocks) lagged the S&P 500 by at least 500%, and 3,431 stocks (23.7% of all active stocks) dramatically underperformed the S&P 500 by 200% or more.
  • 3,683 stocks (25% of all active stocks) lost at least 75%, even before considering the negative effects of inflation (which cumulatively was 96.3%).
  • 6,398 stocks (44% of all active stocks) lost money, even before considering inflation.
  • Almost two-thirds of all stocks (about 9,500 of them) provided no real return, even before considering the impact of taxes.
  • The 80/20 rule works well in stocks. The best-performing 2,942 stocks (just more than 20% of the total) accounted for all the gains; the worst-performing 11,513 stocks (almost 80% of the total) provided an aggregate total return of 0%.

Despite these miserable odds—with only 20% of stocks providing 100% of the returns—investors who broadly diversified through passively managed index funds earned roughly 10% per year (less low costs) and a total return of more than 1,300%. That occurred because most indices are market capitalization weighted.

Successful companies with rising stock prices carry larger weightings in the index. Likewise, unsuccessful companies with declining stock prices receive smaller weightings. Companies showing continued declines are eventually delisted to make way for growing companies.

So, despite the fact that the average (mean) annualized return for all stocks on the S&P 500 Index is negative, the index can still deliver an overall positive rate of return.

Why Diversification Matters

The research, as cited in the aforementioned June 2017 post, shows that most common stocks (more than four out of every seven) do not outperform even virtually riskless one-month Treasury bills over their lifetimes.

The research also shows that individual stock returns exhibit a high degree of positive skewness (lotterylike distributions), meaning a very small percentage of outperforming stocks account for the large majority of returns.

For example, one study that covered the 90-year period ending in 2015 found that 96% of stocks just match the return of riskless one-month Treasury bills. The implication is striking: While there has been a large equity risk premium available to investors, a vast majority of stocks have earned negative risk premiums.

Uncompensated Risk

The study’s finding demonstrates just how great the uncompensated risk is that investors who buy individual stocks, or a small number of them, accept—risks that can be diversified away without reducing expected returns.

Such evidence highlights the important role of portfolio diversification. Diversification has been said to be the only free lunch in investing. Unfortunately, most investors fail to use the full buffet available to them.

This commentary originally appeared August 14 on ETF.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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Chief Research Officer

Larry Swedroe is Chief Research Officer for the BAM ALLIANCE.

Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.

To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored 15 more books:

What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)
Think, Act and Invest Like Warren Buffett (2012)
The Incredible Shrinking Alpha (2015)
Your Complete Guide to Factor-Based Investing (2016)
Reducing the Risk of Black Swans (2018)
Your Complete Guide to a Successful & Secure Retirement (2019)

He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for MutualFunds.com and Index Investor Corner on ETF.com.

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