What If You Don’t Invest In The Best Stocks?

When you review the history of the American stock market from 1926 through the present day, you will find that nearly all of the gains came from just 4% of the publicly traded businesses in existence. For most of the 20th century onward, someone who held shares in Exxon, AT&T, General Motors, IBM, and Apple could claim to represent a meaningful chunk of the stock market.

The data on the poor performance of most stocks ignores the reality that most good businesses merge into the industry titans once they have been successful for a long time and the additional reality that many stocks are too small to provide a meaningful to the S&P 500 performance which is valued at $20.5 trillion.

This data point has been profiled in the working paper of Professor Hendrik Bessembinder at Arizona State University whose work has the non-ironic title “Do Stocks Outperform Treasury Bills?”

The abstract for the paper contains the following the highlight:

“When stated in terms of lifetime dollar wealth creation, the entire net gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks, as the other ninety six percent collectively matched one-month Treasury bills. These results highlight the important role of positive skewness in the cross-sectional distribution of stock returns. The skewness arises both because monthly returns are positively skewed and because compounding returns induces skewness. The results help to explain why active strategies, which tend to be poorly diversified, most often underperform.”

On the surface, this data sounds awful for the individual investor that chooses his own stocks. If only 4% of the publicly traded stocks in existence are responsible for all the net stock market returns, aren’t you taking an enormous risk by building a collection of assets that may not include that elusive four percent?

Yes and no. It is true that the single inclusion of a business like Disney, Becton Dickinson, Colgate-Palmolive, Nike, or Brown Forman held over decades can single-handedly be the difference between a lifetime of 7% or 11% compounding.

But it is not true that you *must* have Exxon, AT&T, General Motors, IBM, and Apple specifically in order to avoid the fate of subpar compounding. Comprehensive stock market data relies on the aggregate performance of businesses totaling $20.5 trillion in market capitalization. You need something like Apple’s $250 billion market cap gain over the past year to move the needle on a national scale.

But you don’t need it to accumulate wealth. If you lived in the Kansas City area your whole life, you could have noticed that the little bank Comerce Bankshares was building new branch locations with organic profits on hand. You could have seen it announce new branch openings in Colorado, Illinois, Kansas, and Oklahoma over the past few years, and chosen to participate in that through a direct purchase program for $150 per month. If you did that for thirty-five years, you would have ended up with over $2 million from that decision. No Exxon. No AT&T. No IBM. No Apple. Just a bank practically no one has heard of.

Why does it take out that way? Because the mathematical reality that is required to make you affluent—turning thousands invested in regular intervals for years into a seven-figure amount—is not even a rounding error compared to what it takes in the aggregate to get a $20.5 trillion asset to move 1%. You need the mega-caps to fund stock market growth. Even if Commerce compounded at 15% for fifteen years, it still wouldn’t move the aggregate stock returns a tenth of a percentage point. And it’s a billion dollar entity.

And secondly, you might wonder: Why is there such a staggering percentage of stocks that don’t make it?

The data set suffers from what I call the “divorce statistic fallacy.” You have probably heard someone claim that you have a 50/50 chance of getting a divorce statistically. This myth became popularized by looking at marriage data trends and dividing the total number of divorces by the total number of marriages. The problem is that the data ignores people who marry multiple times. Once the data accounts for the people with two, three, and four marriages, you see that about 70% of the population gets married once and then never divorces. In reality, your chance of not getting divorced is closer to 3 out of 4 rather than 1 out of 2.

Likewise, data sets are heavily influenced by mergers. Successful companies tend to get bought as they become bigger. At some point in the past century, Clorox stock acquired the corporate entity behind:  Brita water, Burt’s Bees, Fresh Step kitty litter, Formula 409 surface cleaners, Glad trash bags, Hidden Valley dressings, Kingsford charcoal, Pine-Sol cleaning, and KC Masterpiece BBQ sauce.

Those stocks aren’t independent businesses anymore. You can’t buy 100 shares of Kingsford Charcoal stock anymore. So, when it became part of Clorox, it is no longer a stock out there creating wealth—instead, it has become subsumed into one of those 4% of businesses that are credited with generating all the returns even though their origin story had nothing to do with Clorox.

Any time you encounter stock-related information that seems designed to frighten you, always remember this: Steady wealth is created by selling products in an industry that is not subject to a steep drop in product demand in which you can find an assurance that (1) the balance sheet debt is manageable, (2) the specific products you sell will retain a meaningful place within that industry, and (3) there is no noticeable management risk of fraud. Buy multiple assets that meet this criteria, and each addition will add some amount of additional safety.


Originally posted 2017-06-06 23:48:20.

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