The risks of trying to pick future winning stocks

30 May 2017 | Portfolio construction

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It's tough for both professional and personal stock pickers to consistently beat or at least match the market.

But maybe many investors don't recognise just how tough it is for stock pickers to succeed.

Recent research by a US academic underlines that pickers of individual stocks typically have a minimal chance of achieving a satisfactory return for the risks involved.

Professor of finance at Arizona State University Hendrick Bessembinder has compared how the approximately 26,000 stocks that have appeared on the broad US market between July 1926 to December 2015 have performed during their lifetimes against low-risk, low-return, one-month US Treasury bills.

Individual listed stocks tend to have a “rather short lifetime”, he notes. The median time that a stock was listed on the market was just seven years in the period covered by his research.

The findings of Professor Bessembinder's just-released draft paper – Do stocks outperform Treasury bills? – may surprise you:

  • 58 per cent of the stocks failed during their lifetimes to beat the returns of the US Treasury bills.
  • Just four per cent of stocks, a little more than 1000 companies, were responsible for the “entire wealth creation” of the US stock market. (The other 96 per cent collectively matched the returns of the one-month Treasury bills.)
  • Only 86 companies collectively accounted for more than half of the wealth created by the market.

Perhaps the twist with this research is the overall US stock market strongly outperformed the one-month Treasury bills over the research period.

Keeping mind that just a few stocks were responsible for most of the gains, the research provides a resounding case for investors to invest much of their portfolios in low-cost index funds – rather than trying to pick winners.

If you try to pick tomorrow's hot stocks, the likelihood is that you will pick the wrong ones.

Numerous investors, as Smart Investing has often discussed, choose to hold the core of their portfolios in low-cost index funds, tracking selected indices, together with a small selection of actively-managed funds and favoured individual stocks.

Interestingly, Professor Bessembinder has been quoted in the New York Times as saying that he personally invests in widely-diversified, low-cost index funds holding bonds and shares.

 

Written by Robin Bowerman, Head of Market Strategy and Communications at Vanguard.
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Robin Bowerman, Principal, Market Strategy & Communications at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.

Robin Bowerman