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Dilemma of Investing in Stock Market | ASHARQ AL-AWSAT English Archive 2005 -2017
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A man is seen inside the Shanghai Stock Exchange in Pudong financial district. REUTERS file photo

Individual stocks can be hazardous to your financial health.

You may not want to hear that right now, with the stock market regularly hitting new highs.

The Standard & Poor’s 500-stock index set another record on Wednesday after reaching a new high on Monday. It set records on two days the previous week, too. Counting dividends, it has returned more than 6 percent this year and more than 15 percent in the last 12 months.

What’s more, big bets on hot stocks are generating enormous gains. So far in 2017, for example, two companies in the S.&.P. 500 — the biotechnology company Vertex Pharmaceuticals and the video game developer Activision Blizzard — have each returned more than 50 percent to their fortunate shareholders. No question about it, if you pick a sizzling stock at just the right time, you can become rich. Some stock pickers have done well over long periods, too.

But before you jump headlong into stock picking, you may want to consider the odds. It’s not just that bull markets like this one eventually come to an end. It’s that over the long run, while the total stock market has prospered, most individual stocks have not.

A new study by Hendrik Bessembinder, a finance professor at Arizona State University, demonstrates persuasively that while investing in the overall stock market makes sense, the obstacles facing individual stock pickers are formidable. It’s much less risky to invest with diversified low-cost mutual funds.

In a working paper with the provocative title “Do Stocks Outperform Treasury Bills?” Professor Bessembinder found that individual stocks resemble lottery tickets: A very small percentage of winning stocks have done splendidly, but when gains and losses are tallied up over their lifetimes, most stocks haven’t earned any money at all.

What’s more, 58 percent of individual stocks since 1926 have failed to outperform one-month Treasury bills over their lifetimes, he found. That is a low bar, given the piddling returns on one-month Treasury bills, which now yield less than 1 percent.

Professor Bessembinder found that a mere 4 percent of the stocks in the entire market — headed by Exxon Mobil and followed by Apple, General Electric, Microsoft and IBM — accounted for all of the net market returns from 1926 through 2015. By contrast, the most common single result for an individual stock over that period was a return of nearly negative 100 percent — almost a total loss.

All that gloom about individual stocks may seem counterintuitive. After all, it’s often said that stocks outperform bonds over the long haul. That’s why long-term investors are generally advised to hold stocks in their portfolios.

The problem is that the rosy long-term outlook for stocks, as opposed to bonds, is based entirely on the big picture. When you look more closely, the details are disconcerting.

Using a database developed at the University of Chicago, known as CRSP, for the Center for Research in Security Prices, Professor Bessembinder surveyed virtually every stock listed on the broad American market from July 1926 through December 2015. He compared their returns with those of one-month Treasury bills over periods as short as one month and as long as that entire stretch.

Viewed as single units, Professor Bessembinder found, the typical stock does not outperform Treasury bills. Yet taken as a whole, the overall stock market certainly does beat bonds and Treasury bills by very wide margins.

Data posted by Aswath Damodaran, a New York University finance professor, for example, shows that since 1928, stocks returned about 9.5 percent, annualized, compared with only 4.9 percent for 10-year Treasury bonds and 3.5 percent for three-month Treasury bills. In that horse race, stocks won by a mile.

“Many studies have shown that stocks outperform bonds over all, and I don’t question that data at all,” he said in an interview.

How can those two sets of facts — the underperformance of the typical stock and the outperformance of the overall stock market — both be correct?

It is because a relative handful of stocks tend to outperform all others by tremendous amounts.

There is a technical explanation for this. Bear with me. In the language of statistics, the stock market generally has a positive skew — meaning, a relatively small number of outliers like Exxon or Apple have such great returns that they pull up the average stock, which has a mediocre showing. Put another way, the average return is higher than the median or typical return.

What does all of this mean for investors?

It does not imply that stock picking can’t be successful or that it’s wrong for those who do it with their eyes wide open. “Some people who pick the right stocks can have lottery-like returns,” Professor Bessembinder said. “They may want to take that risk and do that.”

But it does imply that most people picking stocks are unlikely to do well for very long.

In response to a question, Professor Bessembinder said that he, personally, favors low-cost index mutual fund investing, through which he maintains a widely diversified portfolio of bonds and stocks.

That is a less risky strategy — though investing in stocks always involves risks, perhaps especially in a period like this one, when stocks have been rising for a long while. And it’s not a revolutionary approach by any means. It won’t produce the stratospheric returns that are possible if you are able to pick the one stock that will outperform all others for the next several decades.

“There’s a good chance that it will be a stock that we haven’t even heard of,” Professor Bessembinder said.
If you are confident that you can identify that stock, good for you. I’m sticking with dull, diversified mutual funds because I know that I can’t.

The New York Times