Yes, 95% of stocks do eventually lose. That’s the bad news. But there’s good news too.
We’ll explain the above claim, and then will suggest a solution.
The stock market has generated incredible wealth for investors over the last hundred years.
But if you’re not careful, you can lose big, as shown by recently-published research.
A comprehensive study of all the publicly-traded companies in the US during the last ninety years found that:
over 95% of individual companies have over the whole life of the company LOST money for their investors.[1]
That’s huge news. It means that if your clients are too concentrated, there is a high probability that such concentration will, sooner or later, bite them hard. In a study conducted by professor of finance Hendrik Bessembinder, Bessembinder’s data suggest that a portfolio which is not properly diversified has a much higher chance of underperforming than almost anyone believes.
The way to avoid the high risk is, of course, diversification. But as we hear frequently, many investors are emotionally wedded to the stock that has, in the past, been so good to them.
Bessembinder’s study
Bessembinder’s study analyzed stock data from companies over the period from 1926 to 2019. The study measured shareholder wealth creation, which included cash flows from stocks such as dividends or share repurchases. The study viewed the initial market capitalization of the stock as a cash flow from shareholders, while the final market cap was considered a cash flow to shareholders. To determine whether investors earned or lost money, Bessembinder compared shareholder wealth against what shareholders would have earned had they instead invested in One-Year Treasurys. Bessembinder found that 95% of the time, an individual company eventually lost wealth for its shareholders. That is, investors would have done better staying invested in T-Bills.
Individual investors on average underperform the market
It’s incredibly difficult to pick winner stocks in advance if you’re not Warren Buffett. (Even Buffett has recently sold some of his large holdings, as addressed recently, “Why is Warren Looking So Grim?”)
Individual investors tend to under-perform the market. This phenomenon has been attributed for a number of different reasons, including: individual investors are influenced by the media, individual investors tend to over-invest in the towns where they live, and individual investors tend to be over-confident in their decision-making abilities.
Many individual investors simply don’t have time or energy to perform extensive research on the companies they invest in. Thus, individuals tend to be influenced by the media and/or by familiarity with certain stocks. Rather than perform a careful analysis of which stocks to invest in, they may invest in stocks because they have heard of them in the media or from friends. According to a study by economists at UC Berkeley, individuals are more likely to buy stocks, rather than sell them, when these stocks are mentioned in the media.[2] This can lead to speculative buying and stocks becoming over-valued.
Behavioral economist Richard Thaler has suggested that one key reason individual investors under-perform the market is over-confidence.[3] Thaler notes that “most” people think that they’re funnier than average – a statistical impossibility if everyone were correct. People also tend to be more confident that they’re right than is justified.[4] In other words, on average, people who own individual stocks think they’re better at stock-picking than they actually are.
That’s not to say that individuals never buy and own big winners. They often do. The problem is that too often these investors make the mistake of believing that because a stock has made them a lot of money in the past, it is a stock they should hold forever.
Past success doesn’t guarantee future success
Even if your clients did a good job (or got lucky) picking a stock that has won, there is no guarantee that it will continue to generate high earnings. Specific sectors that have done well recently – such as technology — have not necessarily done well in the past. For example, tech stocks performed poorly during the early 1970s.[5] Bessembinder reports that, “Technology has not been the most reliable performer in the past.”
The degree to which stock market wealth concentration is not diversified has increased over time. Bessembinder suggests that this phenomenon is consistent with the 2005 hypothesis that the Internet would contribute to more “winner take all” businesses.[6] And even if your stock has made you money in the past, it may currently be over-valued, and/or may lose money in the near future.
Bessembinder’s findings should be a klaxon warning. Given enough time, (often measured in years, not decades) 95% of stocks eventually fail to outperform. And very often, they crash. Just think of household names like Disney and Moderna, both down over 60% from recent highs. Or over a slightly longer period, companies like General Electric which lost over 80% of its value after being a “forever” stock. Or General Motors, which went from being the most important company in the world to bankrupt.
No company is immune. And the bigger the company is, the harder it is to grow. For investors who have ridden a stock up, whether a micro-cap or a mega-cap or anything in between, history tells us to diversify.
And with Bessembinder’s study, history virtually screams: Diversify!
A concentrated position is far riskier than a diversified portfolio
Basic math demonstrates that investing in a small number of stocks, let alone a single stock, is far riskier than investing in many stocks. In other words, the standard deviation of returns, or volatility, is much higher when you invest in a few stocks versus when you invest in many.
If you’d like us to walk you through the math, click here to request a copy of the Appendix from our forthcoming book which explains this in detail.
So even if a stock has “won” in the past, even if it’s a great company, even if it’s the biggest company in the world, that’s no guarantee that it will continue to generate returns as high as it currently is generating, or even positive returns. History says it probably won’t, and could even crash.
How to Diversify Without Tax
A tax-exempt Stock Diversification Trust is a good fit for many people who own a concentrated stock position.
A qualifying stock diversification trust is a tax-exempt entity that allows the client to sell a stock, keep 100% of the proceeds available for reinvestment, and produce income for the client and the client’s family. When we run the numbers, using the trust, instead of selling and paying the tax, the family in most cases can expect to get more than twice as much total net spendable income.
If you have clients who could stand to be more diversified and who have a concentrated stock position, a business holding, piece of appreciated real estate, or some other capital asset that you’d like to help them “take off the table” in a tax efficient manner, please call us to see whether a Stock Diversification Trust might be a good solution. You can also ask us for a free copy of one our Advisor Guides. Click here for a free copy of our Advisor’s Guide to Stock Diversification. Please call 703 437 9720 and ask for Connor or Katherine, or email us at [email protected].
Leave a comment.
[1] Bessembinder, Hendrik (Hank), Wealth Creation in the U.S. Public Stock Markets 1926 to 2019 (February 13, 2020). Available at SSRN: https://ssrn.com/abstract=3537838 or http://dx.doi.org/10.2139/ssrn.3537838
[2] https://faculty.haas.berkeley.edu/odean/papers%20current%20versions/behavior%20of%20individual%20investors.pdf
[3] https://www.barrons.com/articles/overconfidence-could-be-investors-biggest-mistake-richard-thaler-says-51607134013
[4] https://faculty.haas.berkeley.edu/odean/papers%20current%20versions/behavior%20of%20individual%20investors.pdf
[5] https://alphaarchitect.com/2021/10/a-history-of-wealth-creation-in-the-u-s-equity-markets/
[6] Noe and Parker, 2005, https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1430-9134.2005.00037.x
Leave a Reply