Stock Picking Is Difficult- Most Stocks Perform Badly

Henrick Bessembinder from Arizona State University published a research report called “Do Stocks Outperform Treasury Bills?” in January 2017 that looked more closely at returns and equities.

The database consisted of shares listed on the American Stock Exchanges between 1926 to 2015. A total of 26,000 different shares had been listed during this period, and the following observations were made.

• Shares have a short life: the listed median time is only seven years.
• Simulations by choosing only one random stock per month had lower returns than a market-weighted index (such as the S&P 500 for example) in 96% of the simulations.
• Simulations by choosing only one random stock per month made it worse than an equal-weighted index in 99% of the simulations.
• Only 27.6% of equities carried a return higher than treasury bills.
• The 1,000 best shares accounted for all excess returns in relation to treasury bills. These 1000 stocks are only 4% of the shares in the database, which meant that the median share gave a worse return than treasury bills.
• Only 86 stocks accounted for more than half of the return (that is 0.33% of the universe).

The table below summarizes the numbers in 10,000 bootstrap simulations (one stock is invested per month):

Return	1 year	10 year	90 year
>0	53,6%	53,3%	50,9%
>treasury bills	50,7%	48,5%	27,6%
>market weighted index	42,9%	29,8%	3,8%
>equal-weighted index	40,6%	24,3%	1,2%

 

In the example above, the average of all shares is better than treasury bills, but that is because few shares give a very large return: a share can only fall 100%, but can rise for example 10,000% (a share can theoretically rise infinitely).

Look at this arbitrary order of an equilibrium equity portfolio:

Return
Stock 1: -19%
Stock 2: -10%
Stock 3: -9%
Stock 4: -9%
Stock 5: -8%
Stock 6: -6%
Stock 7: -5%
Stock 8: -5%
Stock 9: -4%	Median
Stock 10: -3%
Stock 11: -2%
Stock 12: -1%
Stock 13: 8%
Stock 14: 10%
Stock 15: 21%
Stock 16: 24%
Stock 17:105%

 

The average is 5.11% of all 17 shares, but the median is minus 4%. This is because while only 5 of 17 make a positive contribution, the rest 12 shares make a negative contribution. But because the five shares rise so much, the portfolio gives a positive return.

But if someone were to choose from these 17 stocks by random selection, they would most likely choose a stock that gave a negative return because 12 of 17 gave a negative return (70.6% probability).

The conclusion from the two surveys is that only a small majority of the shares create value. When investing in individual stocks, there is a high probability that a randomly selected stock will do poorly.

What is the solution? The easiest way, of course, is to buy a passive fund. But if you want to invest in individual stocks yourself, diversification is very important.