What’s the difference between stocks and poker?

When I first entered the stock market, I used to think I could beat it. I thought I could pick the best stocks and see the value of my account increasing every day, and this same feeling affects most people in the market. This is also what happens to most people at a poker table. Sometimes you just need to lose some money to get rid of your arrogance.

The problem is that by listening to news from the stock market you constantly hear about stocks that beat the market. You hear about Amazon or Apple and their amazing returns, but you hardly ever hear about the penny stocks that are just a tombstone of a marvelous past.

A new academic study “Do Stocks Outperform Treasury Bills?” by Hendrik Bessembinder, a finance professor at Arizona State University, focuses on whether or not stocks outperform Treasury bills (also called T-bills). Stocks are known to produce solid gains over the years, while T-bills are a short-term debt back by the U.S government and thus carry perhaps the lowest risk of all financial vehicles. The lowest risk, as always, comes with the lowest return, so to even think that the return on T-bills can be higher than that of stocks sounds ridiculous. But is it?

Do stocks outperform Treasury bills?

The research involved a great amount of data—25,782 different stocks and more than 3 million monthly returns from 1926 through 2015. Some companies had changed their operations, some had gone through bankruptcy and returned under a new symbol, some had merged or been acquired, and in such research based on a fluctuating historic sample, the methodology used can have a profound effect on the result. Still, the results are astonishing. The way they were obtained is less important.

The main conclusion is that while the overall stock market outperforms Treasury bills most individual common stocks do not. Of all the stocks that were researched, less than half generated a positive holding period return, and only 42% have a holding period return higher than the one-month Treasury bill over the same time interval.

What every investor should learn from this research is that the impressive performance of the stock market is attributable to large returns generated by very few stocks; in fact, only the best performing 4% of stocks accounted for all the wealth created by the stock market during that period.

Picking stocks—What is it good for?

Absolutely nothing, as the song says. If you picked the right stocks, you surely haven’t had any regrets. Yes, I’m talking about those 4%. But what are the odds of knowing in advance what those stocks would be? Most of the wealth accumulated in the market is attributable to a tiny number of stocks. ExxonMobil’s wealth was more than $900 billion, while Apple created $677.4 billion in shareholder wealth despite a relatively short lifetime. General Electric ($597.5 billion), Microsoft ($567.7 billion), IBM ($487.3 billion), Altria Group ($448.1 billion), General Motors ($394.1 billion), Johnson and Johnson ($383.7 billion), Walmart ($337.7 billion), and Procter and Gamble ($335.8 billion) comprise the rest of the top ten stocks in terms of lifetime value creation.

In real life, however, you are likely to miss these winning stocks. Some people might succeed, but most will not. When Apple was about to bankrupt, who thought it is going to be the largest company in the world, by market capital? Every company’s stock belongs to people who think they have a winner, but most of them tend to be losers . . . at least compared with T-Bills, which do not carry any risk. Accordingly, if you want to enjoy the returns of the market (represented by the indices), you should diversify your portfolio. For best results, it would feature very low fees ETFs that track the major indices. These indices comprise those winning stocks (and also the losers). If you are exposed to the S&P 500, you are exposed to the biggest companies of the American economy, and then you are exposed to those winners because one way or another they will be found in this index.

Bottom line

Here’s a quote from the study that pretty much summarizes the topic in a perfect way: “Not only does diversification reduce the variance of portfolio returns, but non-diversified stock portfolios are subject to the risk that they will fail to include the relatively few stocks that, ex-post, generate large cumulative returns. Indeed, the results help to understand why active strategies, which tend to be poorly diversified, most often lead to underperformance. At the same time, the results potentially justify a focus on less diversified portfolios by those investors who particularly value the possibility of ‘lottery-like’ outcomes, despite the knowledge that the poorly-diversified portfolio will more likely underperform.”

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