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How Missing Out On Just A Few Winning Stocks Can Tank Your Portfolio

It may seem surprising, but even though the stock market, in aggregate, has been a great investment historically, individual stocks often haven’t been. Hendrik Bessembinder of Arizona State University has documented. There are a few reasons behind this. Individual stocks aren’t around long, for the 1926-2016 period the average stock exists for just seven and a half years, and of all the outcomes a total loss is the most common. Over half of stocks lose money over their lifetimes. You may of course ask why investing in stocks is such a good idea, if the returns to individual stocks can be so poor. The reason is that a few winners can do incredibly well, but crucially if you don’t own those winners you can easily lag the market. This means that trying to hold a concentrated stock portfolio is a risky strategy. Bessembinder finds that if you just pick a different single stock every month for the past 90 years, you would lag the market 19 times out of 20. Picking the big winners is therefore important, but also challenging, for example Exxon, Microsoft, Apple, GE and IBM account for 10% of the market’s return to 2016. That’s just 5 stocks out of a field of more than 25,000 providing a tenth of the return. In fact, a little over the best performing 4% of companies have produced literally all the market’s historic return on Bessembinder’s numbers.

Skewness

What we are dealing with here is skewness, where the average does not represent the overall performance of stocks that fairly. A few stocks offering stellar returns is what leads to great index performance. Missing big winners can be extremely costly to portfolio performance. To put it another way over a decade the historic average return to a stock is 108%, but the median return (if you ranked all the stock’s returns and took the middle value) is 16%. Great performers pull up the average massively.

What To Do About It

This leads to three potential strategies. The first is to make sure you find that needle in the haystack. However, as the data shows this is extremely challenging and perhaps requires greater diversification than most investors realise. Yes, diversification may help smooth returns, but perhaps more importantly it helps increase the odds of making sure big winners are in your portfolio. Nonetheless, if you’re running a concentrated portfolio you should be aware of the risks you are taking, it’s unlikely you’ll see average returns, you’ll either substantially beat the index if you’re exposed to the relatively rare winners, or lag it perhaps substantially if you are not. The latter outcome seems more likely based on the numbers. 

The second approach is indexing. Given it’s so important to returns to own the winners, the owning as many stocks as you can can prove a robust strategy. Exchange Traded Funds (ETFs) offer one way to do this, and you should look at the number of stocks the ETFs hold as well as the expense ratio (the cost). If you own a low-cost ETF holding thousands of companies, then you’re more likely to achieve the average returns of the market and be less impacted by the potential problem of skewness. Basically, the closer you come to owning the overall matter, the less the skewness of returns matters to you. A third area to investigate is the concept of momentum. Momentum is the strategy of owning past winners and has been shown to help portfolio returns over time. Perhaps Bessembinder’s work helps explain why momentum works to a degree. If we know that big winners are rare, but important to a portfolio, than owning stocks with relatively strong historic performance may be a useful pool to draw on. Of course, we don’t know that all of those stocks will work out well, but it’s perhaps probable that the big long term winners will be over-represented in the better performers of the short-term, and momentum gets you exposure to that. So, be aware of extreme skewness in stock returns. The average fails to tell you that. It probably means you need to diversify more than you think. Otherwise your returns may look quite different to the overall market.