Finding and holding the needles in the haystack (Photo: freepik, BillionPhotos)
Stock pickers often don’t want to admit it or argue that they don’t care about the outperformance of a broad ETF. But the question certainly arises as to why investors would want to forego a significantly higher return just to own a portfolio that they put together themselves.
In many cases, stock picking seems like an expensive “hobby”. For example, if you only lag behind the market by one percentage point annually over a period of 10 years, you are missing out on a return of around 10 percent overall.
Bessembinder study: individual stocks vs. index
Hendrik Bessembinder is a renowned financial scientist who analyzes the returns of more than 25,000 US stocks over a period of 90 years (1926 to 2016) and the Results (PDF) published. He paid particular attention to the total return of each share over its lifespan, i.e. from listing to delisting.
In contrast to other studies, he examined the return of individual stocks in relation to the entire market portfolio – instead of the average return of the index. This is because the average return only reflects the general performance of the market, but it does not take into account whether individual companies contributed much more or less to the return. The question was how much wealth individual stocks actually create – as opposed to the mere relative return of the market as a whole.
Sobering realization: government bonds clearly outperform individual stocks
The Bessembinder study clearly showed that 60 percent of stocks lag behind the returns of short-term government bonds. The reason for the outperformance compared to the index is due to only 4 percent of the stocks. They move the index up in the long term. A very small proportion of shares generate a disproportionate amount of value.
Of the more than 25,000 stocks examined, only the top 86 companies created 50 percent of the U.S. stock market’s total value. Stocks like Apple, Microsoft and Exxon Mobile were the biggest drivers of overall market returns.
What are the reasons for this sobering result?
The reasons are complex and include the power of innovation, network effects and the cyclical nature of many companies. Companies like Apple and Amazon have revolutionized entire industries and created enormous value for shareholders. Network effects led to enormous economies of scale and market share gains as well as exponential profit growth.
However, other companies and industries are affected by cyclicality and regulations. These companies often struggle to generate consistently high returns over the long term. As a cyclical, Exxon was only able to ensure competitiveness and benefit from increasing market shares due to its economies of scale and negotiating position.
Added to this is its impressive dividend history, which attracted many long-term investors and increased confidence in Exxon. In general, stocks that exist over the longer term have a higher chance of becoming super stocks.
The best stocks returned an average of 13.5 percent
The few best stocks shone with an outperformance of the index and were able to achieve an annual return of 10 to 20 percent over decades, but on average the annual return was still only a modest 13.5 percent. For example, if you had 1 dollar in 1965 Berkshire Hathaway invested would have made over $22,000 to date. The same amount invested in the S&P 500 would have yielded just over $155.
The problem, however, is finding such super stocks and subsequently holding them. The longer you stay invested, the stronger the compound interest effects, which allow the capital to grow.
Find and hold the needles in the haystack
The distribution of returns for individual stocks is strongly positively skewed. This means that only a few stocks produced very high returns, while most stocks produced either no or low returns. These few “super stocks” are the reason why ETFs perform so consistently. Outperformers remain in the index, while bad companies are regularly eliminated or taken off the stock exchange entirely.
With a concentrated portfolio, it is particularly difficult to hold a “super stock” in the portfolio over the long term, especially since the investor not only has to find the needles in the haystack, but also has to hold on to it through all cycles. Investors tend to sell winners early or take partial profits.
A particularly outstanding example is Nvidiawhich achieved the best annual return with an annualized return of over 30 percent over at least 20 years. This shows that not only time is crucial, but also the ability to retain companies with strong growth potential.
ETFs offer secure returns over decades
The main point of the study is that picking individual stocks is like looking for needles in a haystack – you can make big gains, but for every Apple or Berkshire, there are plenty of losers. The lesson for investors is that active stock picking comes with high risks, and broad diversification into ETFs is a much safer way to achieve solid returns over the long term.
Disclaimer:
Not investment advice. No call to buy or sell securities.