Stock picking is extremely difficult. I met an individual the other day that wanted to build a portfolio of large well-established companies and expect to out earn the market with this strategy. This is a very common belief but a mostly incorrect way to think about expected returns. Let me explain why.
Largest US Stocks by the Decade
This next chart shows the staying power, or lack thereof, of the largest US companies by market capitalization. Five new companies are on the list for 2020 that were not there in 2010. Exxon & General Electric fell out of the top ten after NINE decades in the top ten. (As of this writing, General Electric now sits as the 72nd largest stock in the US.). Once a firm reaches top ten status, there is no guarantee it’s going to stay there. Look at all the big companies that have come and gone through the decades.
Top Stocks Do Not Always Continue to Be Top Performers
In addition to the above, top stocks have always accounted for a large portion of the market yet tend to underperform once they reach top 10 status. See research from Dimensional Fund Advisors on this. Once a stock reaches the top 10, on average, it will underperform the wider market by 1.5% annually in the next ten years.
Nearly All the Market’s Return Comes from a Remarkably Small Number of Stocks
In the long run, nearly all of the market’s return comes from a remarkably small number of stocks—giant winners that rise in value by 10,000% or more over the course of decades. A dated yet very much relevant 2016 article by Jason Zweig outlines this phenomena nicely:
From 1926 through 2015, only 30 stocks accounted for one-third of the cumulative wealth generated by the entire U.S. stock market. That’s 30 out of a grand total of 25,782 companies that were publicly traded over that period or a whopping 0.11%.
Only 90 stocks or 0.33% of all companies that were part of the U.S. stock market at any point over those nine decades accounted for half of all the wealth generated for investors.
The 1,000 top performers since 1926 — under 4% of all stocks — account for all the stock market’s gains, research shows. You could have matched the returns of all the other 96% of stocks combined by putting your money in one-month U.S. Treasury bills.
If someone wants to gamble on a few select companies with a small part of their wealth that will not impact their retirement or legacy goals, great. You have my ok. However, with money that is critical to the success of your family’s future, I prefer a tried-and-true evidence-based investing approach which is outlined in my last blog post titled: Our Investment Philosophy Is Rooted in Academic Research. Then the odds are in your favor.