Don’t Lose Sight of the Investment Forest for the Trees

Editors' Note: MarketMinder does not recommend individual securities. The below merely represent a broader theme we wish to highlight.

Do stocks outperform Treasury bills? The widely accepted answer is yes-and by a significant margin over the long term. However, one paper recently challenged this conventional wisdom, arguing most stocks aren't great investments because only a sliver-less than 4%-have generated all the return. This prompted responses from financial pundits, with some asking if stock investing is a futile exercise akin to finding a needle in a haystack. However, in our view, this conclusion misses some important context and wrongly focuses on the importance of individual stocks-not the most critical ingredient to successful long-term investing.

The paper in question found, "The positive performance of the overall market is attributable to large returns generated by relatively few stocks." Specifically, the author tracked 25,782 stocks since 1926 and found the top 1,000 performers-less than 4% of the total-accounted for all of the stock market's wealth creation. Even more striking: 86 companies generated more than half of those returns. With positive performance overly skewed by a handful of high-flyers, the paper argued most common stocks-about 4 out of 7-don't outperform Treasurys over their lifetime, and that less than half (49.2%) have a positive lifetime return over a holding period of ten years. Thus, the paper concludes actively picking good stocks is a futile task since the odds are overwhelmingly against it.

While historical data are fun to play with, the paper lacks some important context for the long-term, growth-oriented investor. While tracking returns for 26,000 stocks over 90 years sounds like a robust dataset, this portrays market history as static-yet it is very dynamic. As the paper notes, "Just thirty six stocks were present in the database for the full ninety years." Of those 26,000 stocks, the median lifespan was just over seven years. While that may sound bad at first blush, it also makes sense: Companies go bankrupt and fail all the time, and new businesses emerge and take their place.^[i] That's how the business cycle works, and just because a firm was successful in 1925 does not mean its model will last until 1965, 1995 or 2015. So inevitably the number of "losers" in this dataset will only rise over time. In contrast, not every firm in the "winners" column will enjoy this unidirectional movement. One company's good fortunes today could flip in the not-too-distant future when the economy shifts.

To illustrate how drastically the economy can-and has-changed, consider this fun, though trivial, anecdote: At the end of 1925, Remington Typewriter joined the Dow sporting a $113 ½ share price.^[ii] It merged with the Rand Kardex Bureau and Dalton Adding Machine Company a little more than a year later, and on its last day in the Dow on March 15, 1927, Remington traded at $168.^[iii] Almost 90 years later, Apple-currently the world's biggest company by market cap-entered the trivial index^[iv] at a price of $127.50 on March 19, 2015.^[v] Unlike Remington's relatively short stint, Apple is still listed in the Dow with a share price of $153.99 as of May 22, 2017.^[vi] The vast differences between those two companies' products-and their applications to day-to-day life-show how much the economy and markets have changed over the past century.^[vii] Investors need to account for this dynamism in their investment plan. Basing forecasts solely on past performance is always an error.

This super high-level historical approach also isn't practical for many investors. Over the course of 90 years, capital markets will look littered with failed firms and dud stocks. However, most regular investors don't have 90-year time horizons-the timeframe they need their investments to work for them. Even during your time horizon, there is a fair likelihood you'll need some sort of cash flow from your portfolio, which may necessitate selling stocks or even changing asset allocation (depending on your personal circumstances). Moreover, time horizon isn't necessarily equal to an appropriate holding period for a stock. If your time horizon is 30 years, your personal needs will change as you get closer to the end of that period-perhaps necessitating portfolio adjustments. You will probably also adapt to market conditions as they evolve. Thus, chances are you won't be holding the same individual security the entire time.

Plus, even if most stocks fail in the very long term, that doesn't prevent investors from reaping and enjoying long stretches of gains along the way. Exhibit A: Bear Stearns. Though most folks today only remember the precipitous plunge of Bear Stearns's stock during the last bear market-and perhaps its acquisition by JPMorganChase-the bank was one of the country's most successful financial firms for decades. It wasn't until Q4 2007, near the firm's demise, when Bear recorded the first loss in its 85-year history. As historical stock price charts show, Bear Stearns did pretty well before its failure-easily a meaningful enough period for investors to capitalize. Heck, in the 20 years preceding its January 18, 2007 high, Bear posted trailing returns of 2,120.4%.^[viii] Not the biggest, but not a disaster by any stretch. If you need growth, reaping those kinds of gains is integral.

Moreover, if an investor owns a globally diversified portfolio, this discussion about a handful of individual stocks is largely for naught. The explosive returns of high-flyers-like a prominent online retailer that IPOed 20 years ago-naturally grab attention. However, long-term investors don't need to hunt for the needle in a haystack-not every holding needs to be a homerun for your portfolio to grow. For example, during the October 9, 2002 - October 9, 2007 bull market, the vast majority of stocks that spend the entire span in the the S&P 500-specifically, 410-were positive; just 22 were negative.^[ix] Even accounting for the caveat that these data exclude 68 firms delisted during the bull (either due to failure, merger or private equity buyout), more than 80% of the S&P 500 was positive. Plus, 228 of those firms outperformed the S&P 500's 120.7% total return during that bull market.^[x] That is more than a handful. Our point: Investors' portfolios should not only have enough in stocks, they also need to own enough stocks to get market-like results. By properly diversifying-ensuring no individual company comprises more than 5% of your portfolio-you decrease the risk and potential damage if one or more holdings unexpectedly tank.

Investors face a lot of noise, especially with the financial media's myopic focus on individual securities. It could be tempting to adjust your portfolio based on what's hot (and not). Likewise, the rarity of "super stocks" could make stock investing seem like a fool's errand. But a big part of successful long-term investing is tuning out the noise and ensuring your plan is designed to meet your individual goals-that's what matters most.