Best of: Most Stocks are Duds (But You Can Win Anyway)

By TradeSmith Research Team

Editor’s note: We come across a lot of research, and the study performed by Hendrik Bessembinder earlier this year was one of the most eye-opening we’ve seen.

If you have a poorly performing stock in your portfolio, hoping it might make a comeback, here is some bad news: That comeback isn’t likely. Most “dud” stocks tend to stay duds.

Not only that, it turns out well over half of all stocks lose money — even during bull markets, and even over a time frame of decades!

These are the surprising implications of a study performed by Hendrik Bessembinder, a professor at the W.P. Carey School of Business at Arizona State University, and his team.

“It is historically the norm in the U.S. and around the world that a few top-performing companies have great influence over how the market does overall,” Bessembinder told Bloomberg. “It’s the norm and I expect it to be the case in the future.”

To call it “historically the norm” is a dramatic understatement. It is shocking how much a small group of stocks tends to drive market returns, and how routinely most stocks lose money.

To conduct the study, Bessembinder and his team examined the performance of 62,000 stocks traded in more than 40 countries, covering the time span of 1990 to 2018.

This 28-year time period encompassed powerful bull runs, harsh bear markets, and multiple market crashes, running the gamut of business cycles and market conditions.

Two years ago, the same team conducted a study on U.S. equities only. The latest was an “entire world” version. The U.S.-only study from two years ago looked at 26,000 stocks over a time period of almost nine decades. In terms of concentrated winners and widespread losers, the results were similar.

Again, it is truly shocking the degree to which market performance comes from just a handful of names.

For example: Between 1990 and 2008, just five stocks — Apple, Microsoft, Google, Amazon, and Exxon Mobil — accounted for $3.5 trillion worth of global net wealth creation.

Taking a step back, the top 306 stocks in the global study — about 0.5% of the total — accounted for an incredible 73% of equity wealth creation. Almost three quarters of the stock market gains, across the entire planet over nearly 30 years, came from 306 names. 

If you zoom out a little further to the top 811 stocks — about 1.3% of the total pie — the performance of that exclusive group covers the entire $44 trillion worth of net equity wealth created circa 1990-2018. 

Far more than just 1.3% of stock names were profitable, of course. Out of 62,000-plus names, the percentage with positive returns in the period was about 39%.

But roughly 61% of names in that period had negative (wealth-destroying) returns, which canceled out about $22 trillion worth of gains. That is why the top 811 stocks represent the net gain of $44 trillion.

Again, the sobering reality here is that most stocks lose money — even over long periods, and even with historic bull runs factored in. But it doesn’t have to be bad news, as we shall soon see.

There are at least three ways to benefit from the results of this study.

The first way is to double down on a passive investing approach. If you own entire indices like the S&P 500 or the Russell 2000, you will own the big winners mixed in with the flotsam and jetsam. Those winners should then overpower the duds in the long term, giving you the average index return.

The second way (our preference) is to stick with individual stocks but maintain a ruthless sense of discipline in cutting the underperformers out of your portfolio.

After all, if a stock is showing signs of being a dud, based on simple probability, there is a better than 60% chance the stock will lose money — even over the long term.

The third way to take the study to heart is a corollary of the second. If you buy individual stocks, then search for big winners and get in the habit of letting your winners run!

The stocks that build generational wealth are like championship thoroughbreds — the Sea Biscuits and Secretariats and Seattle Slews of the investing world. And just like first-class racehorses, winning stocks are not common. They are more like one out of 50, and the legendary world-beaters are more like one out of 1,000.

So, when you get your hands on a top performer, hang onto it.

One way to do both things consistently — cut away underperformers while sticking with strong trending winners — is with investment software designed to help you do exactly that.

The best measure of how a stock is doing is how it is behaving, because a great deal of institutional analysis is already baked into the price. TradeStops’ Stock State Indicator (SSI) can give you an indication of a stock’s health with just three colors: red, yellow, or green (you want green).

Then too, riding winners means staying with long-term trends.

If you identify a great name, then as long as it shows a positive trend, you want to own it. Trying to jump in and out — getting fancy in terms of small corrections — can make you miss out on the really big move.

Last but not least, combining SSI with trend signals can deliver the best of both worlds. That, in turn, hints at how investors still can beat the pants off the “average” stock market return.

If you focus on just owning winners, while culling underperformers and sticking with big trends, you’ll be standing out in a way that most investors don’t. This is hard to do without the proper tools, but far easier with great investment software. 

So maybe Bessembinder’s gloomy study — which shows that most stocks lose money and a small handful of winners drive most of the returns — doesn’t have to be gloomy after all.

TradeSmith Research Team