<b>A common criticism of index funds is that they own losing stocks as well as winners. It’s true, they do. But does it actually matter?</b>
Every investor loves a winning stock. As for losing stocks, most investors, given the choice, would avoid them like the plague.
It’s perfectly natural that we should feel this way, both from a neurobiological and a behavioural perspective. Winning stocks activate the brain's reward system, releasing dopamine, a neurotransmitter associated with pleasure and reward. Losing stocks can induce the release of cortisol, a stress hormone, which often results in heightened anxiety and fear. Also, because of a bias called loss aversion, investors tend to experience the pain of losses more intensely than the pleasure of equivalent gains.
But what if we told you that owning losing stocks is inevitable, and that coming to terms with that fact will help you to achieve your investment outcomes?
<h4><b>Most (yes, most) stocks are losers</b></h4> Strange as it may seem, the vast majority of stocks are losing stocks. Yes, you read that correctly. A <a href="https://wpcarey.asu.edu/department-finance/faculty-research/do-stocks-outperform-treasury-bills">study</a> by Professor Hendrik Bessembinder from the WP Carey School of Business at the University of Arizona, analysed the performance of more than 26,000 US stocks between 1926 and 2019. What he found was that, although the overall U.S. stock market has outperformed Treasury bills (or US government bonds) in the long run, most individual stocks have not. Specifically, less than half of the stocks he analysed generated positive lifetime returns, and only 42.6 percent outperformed one-month Treasury bills.
How, then, can we explain the fact that U.S. stock markets nevertheless delivered very positive returns to investors during that period? The answer, says Bessembinder, is that the market's net gain was driven by a small percentage of highly successful stocks. Indeed, market returns were wholly driven by only the top four percent of companies.
In other words, Bessembinder’s research provides strong evidence of what statisticians call positive skew in the stock market. Simply put, the best-performing stocks have experienced outsized returns relative to the rest of the market.
<h4><b>Very few stocks survive in the long run</b></h4> Now, in a newly published <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4897069">study</a>, Bessembinder goes deeper into the individual stocks that have experienced the biggest gains in market history. What he finds this time is that, out of more than 29,000 stocks, just 38 of them survived the entire 98-year period from December 1925 to December 2023.
Again, though, that is more than offset by the winners. Just 17 stocks, Bessembinder finds, had cumulative returns of more than <i>five million</i> percent!
Interestingly, the technology company Nvidia had the highest annualised return of any stock with at least 20 years of data at 33.4% per year. The best-performing stock over the entire period was the tobacco manufacturer Altria, with annual returns of 16.3%.
<h4><b>Takeaways for investors</b></h4> So what does all this mean for investors? There are two key takeaways.
<h5><strong>1. Picking winners in advance is very hard, so index instead</strong></h5> The most important lesson is that identifying, in advance, the stocks you can invest in now that will provide the very best returns in the future is extremely difficult — not least because there are so few of them.
If you invest actively, either by picking the stocks yourself or paying a fund manager to do it for you, it is extremely unlikely that you will own all of tomorrow’s best-performing, publicly-listed stocks. But the good news is that you can <i>ensure</i> you own them by simply investing in index funds. True, it means you will automatically own all of the losers. But that pales into insignificance compared to owning all of the big winners as well.
As my co-author <a href="https://awealthofcommonsense.com/2024/07/the-biggest-winners-in-the-stock-market/">Ben Carlson</a> explained in a recent blog post: “The stock market is hard to beat because picking the winning stocks is hard. Index funds own them regardless.”
<h5><strong>2. It’s not timing the market but <i>time in</i> the market that counts</strong></h5> There is, however, another important lesson to learn from these studies, and that’s the value of patience and discipline.
Yes, market returns are driven by a tiny proportion of stocks producing truly extraordinary returns. But what Bessembinder’s latest study shows is that, on average, the annual returns of these mega-stocks are lower than you might expect, at 13.5%.
As Carlson puts it: “There are no stocks for the long run with crazy 20 or 30 percent annual returns over eight or nine decades… It’s not like the best-performing survivors crushed the market by leaps and bounds.
“But those above-average returns compounded over 98 years added up to incredible growth over that time. That compounding has been magic for the stock market.”
<h4><b>Are you on course?</b></h4> So, are you on course to benefit from the magic of compounding by investing for the long term in index funds?
If you aren't, why don’t you <a href="/contact/">come and have a chat</a> with us so we can get you up and running?
