Should you invest in the stock market?
The answer to this question seems fairly obvious: Over the past ninety years, stocks have returned, on average, 10 percent per year, far outpacing bonds (about 5 percent) and cash (less than 3 percent).
So, why am I asking if you should invest in stocks? The reason is because of the words “on average” in the sentence above. Stock market returns are, of course, uneven from year to year, and uneven from stock to stock. That is well known. But, the degree to which stock performance varies from stock to stock may surprise you, and that has implications for how I think you should invest.
In a recent paper titled “Do Stocks Outperform Treasury Bills?” Hendrik Bessembinder, a professor at Arizona State University, provided these unexpected insights:
1. Between 1926 and 2016, just 4 percent of all stocks accounted for all of the net gains in the U.S. market. All other stocks, as a group, delivered returns that were no better than Treasury bills, which have returned just 2 percent per year over that timeframe.
2. Over that same time period, more than half of all stocks would have delivered a negative return to a buy-and-hold shareholder. In fact, the single most common return was negative-100 percent — in other words, a complete loss.
3. Treasury bills have historically returned just 2 percent per year. And yet, for any given stock in any given month, the odds of beating Treasury bills are just about even. Actually, Treasurys have a slight edge, beating individual stocks 52 percent of the time.
What should you conclude from this? Am I trying to say that you shouldn’t invest in the stock market? No, I still see stocks as the best way to grow your wealth over time. However, I do see three important implications:
1. Diversification is vital, maybe more important than you might have guessed. Since market gains are so skewed toward such a small number of stocks, it’s critical that you own those winners — companies like Apple and Amazon and Biogen that have grown exponentially over the years. Amazon’s stock, for example, has grown 20-fold over the past ten years and more than 200-fold over the past twenty years. Of course, it’s very hard to separate the future Amazons from the future Enrons, so that’s why I think your best bet is to own broadly-diversified index funds, which will give you a slice of every company, allowing you to be sure you own those extreme outperformers.
2. While the S&P 500 is a great starting point for any portfolio, you shouldn’t stop there. When you buy index funds, make sure you include mid-cap and small-cap holdings, which are where the future Apples and Amazons may be found today.
3. I don’t recommend buying individual stocks, but Dr. Bessembinder’s study does provide an important caveat: If you are able to identify a future winner, it could make all the difference. In fact, as I have pointed out in the past, most of the world’s great fortunes — Gates, Carnegie, Rockefeller and the like — came from single stock holdings. So, if your field of expertise provides you with unusual insight in a particular area, you might be in a position to spot a future Medtronic or Biogen or Qualcomm when they’re just getting started. And the good news is this: If you are right, you don’t need to invest a lot. For example, in 1997, if you had invested just a thousand dollars in Amazon, you’d have a million dollars today. That’s important because you still want to keep the bulk of your portfolio broadly diversified.
Don’t get me wrong. I still think the best way to make money is in the stock market. And, I still think the best way to make money in the stock market is with simple index funds. But, this study is a good reminder that both of those statements must always be qualified with the words on average.