Is It Critical To Pick The Right Stocks?

Is it critical for an investor to pick the right stocks to invest in? Or is there an easier way to invest in stocks, given that the majority of investors are not good stock pickers in the first place?

If there is ever a debate which cannot be settled satisfactorily despite the existence of incontrovertible evidence one way or another, it has to be this! Call it what you may – active versus passive investing, stock picking versus index investing – both sides have their die-hard adherents. And this, even after reams of research, such as from Standard & Poor’s, showing that 92% of mutual funds (presumably the active investing stock pickers) underperform the broad market index over 15 years! After all, there is nothing a stock investor likes better than picking up stock tips, preferably backed with insider insights and analysis of financial statements, and a large industry of stock analysts has sprung up in print and online to cater for this.

So this debate is unlikely to be ended even with Bessembinder et al’s study of the returns on 64,000 global stocks over a 31 year period (Jan 1990 to Dec 2020). But it is worthwhile taking a plunge into the paper to see what insights it may offer.

Are you picking the right stocks?

Picking The Right Stocks To Invest In – The Global Winners

Let’s start off with what everyone is most interested in. Which are the stocks that have delivered the most value for shareholders from 1990 to 2020? The top 50 are below:

The Top 50 Global Stocks 1990 – 2020

Source: Bessembinder et al (2023)

To nobody’s surprise, US stocks dominate the list, with everybody’s favourite stocks of the last decade, such as Apple, Microsoft, Google, Facebook, Amazon, Tesla, Netflix, Nvidia topping the rankings. Chinese banks and tech firms can also make it here, as well as some old economy stalwarts like Walmart, McDonalds, JP Morgan Chase, Coca Cola, and PepsiCo.

With the benefit of hindsight, it does not seem that difficult to have picked these stocks for our investment portfolios. After all, almost everyone of these stocks debuted on the stock market as large cap stocks, with economic moats, and thereafter enjoyed an almost uninterrupted period of share price increases.

But investing for the long term as a stock picker is not always easy. What do you do, for example, if there is a sharp and sustained decline in the share price? Do you stick with your picks, or do you start picking something else? For example, both Apple and IBM sustained a sharp decreases in value in the first decade, with Apple dropping by 63% by 1997 and IBM by 58% by 1993.

Are you able to stomach such losses as a stock picker?

Picking The Wrong Stocks to Invest In The Global Losers

At the other extreme, stock pickers also run the risk of picking the wrong stocks to invest in. Again, hindsight is 20-20, but looking at the list of the biggest wealth destroying stocks, it is not obvious that these would have ended up at the bottom of the list. Japanese banks dominate of course, but 1990 was the peak of the Japanese real estate market after all. And there are the failures from the tech bubble, like WorldCom and Lucent. And also those from the Global Financial Crisis, like Natwest, Unicredit and Wachovia.

The Bottom 20 Global Stocks 1990 – 2020

Source: Bessembinder et al (2023)

At this point in time, some of the top stocks from China, like AliBaba and Tencent, have also experienced losses over the past couple of years on par with the sharp falls in Apple and IBM back in the 1990s. Which once again poses the “hold or sell” question for the stock pickers.

Will Investing In The Stock Market Index Be Better?

Although Standard & Poor’s has painstaking documented the long term underperformance of mutual funds relative to the stock index, Bessembinder et al (2023) go a little further by trying to demonstrate why this is so. This is the interesting part of their research. Looking over 30 years of returns on 64,000 stocks, unsurprisingly, they find that individual stock returns (inclusive of reinvested dividends) are skewed. What this means in practice is that stock returns can be very, very high. Unlimited, in fact. At the same time, you cannot lose more than 100%. We show this below:

Skewness in Individual Stock Returns 1990 – 2020

Source: Bessembinder et al (2023)

What this implies is that there may be very slightly more individual stocks returns that are less than 0% than those which are more than 0%. This is to make up for the fact that these positive returns can go up infinitely. So if you held onto a single stock forever, the only guarantee is that you will lose everything eventually. It’s a little like gambling in a casino, the gambler’s ruin effect.

If, however, you invest in a diversified portfolio, the central limit theorem will help ensure that the effects of the gambler’s ruin are minimised, or even eliminated. And that is what they demonstrate in their research, by assembling random portfolios of 1, 5, 25, 50 and 100 stocks, and seeing whether they can outperform a 0% return, a T-bill return and a stock index return over 5, 10 and 31 years.

Can a Small Portfolio of Stock Outperform a Stock Index?

Source: Bessembinder et al (2023)

Let’s look at the rightmost column of the table, starting at the top. We see that a single stock position in a random US stock has a 30% chance of having a return higher than 0% over 31 years. This single stock portfolio has only a 7.8% chance of beating the stock index over 31 years.

Moving down the column, a 50 stock portfolio has a 100% chance of having positive returns over 31 years, but only has a 42.9% chance of beating the stock index over the same span of time. Which is a surprising result, since Standard & Poor’s tells us that 92% of mutual funds cannot beat the market index over 15 years! So assembling a random portfolio of 50 stocks and just holding on to it will still be better than putting it into a professionally managed active investment fund!

Why is Stock Picking Hard?

Finally, Bessembinder et al (2023) also show us a bit of why stock picking is hard. While the Global Top 50 stocks have created a lot of wealth of their investors, there are actually very, very few stocks which do so. In fact, only 1,526 stocks out of the 64,000 studied (2.4%) account for virtually all the wealth created in these stocks over 1990 to 2020! A further 23,915 stocks (37.5%) have positive returns, but this is completely wiped out by the last 36,618 stocks (57.7%)! This is shown below:

Cumulative Percentage of Global Dollar Wealth Creation 1990 – 2020

Source: Bessembinder et al (2023)

Actually, after the first 8,000 top stocks or so (about 16%), the cumulative returns will be quite mediocre. Hence, the question for a stock picker really comes down, in a way, to: “How confident are you of being able to pick the best 16% of all stocks?”

But this is an advantage for passive, index investing. Why? Because all the top global stocks will eventually do so well that they form a part of the stock market index. So investing in the index will guarantee that you will get a piece of the action, not matter how difficult it is to pick the right stocks!

Why It Is Not Critical to Pick the Right Stocks

Stock picking is hard, without doubt. In most cases, passive index investing will give comparable, if not better results. Yet, “hope springs eternal in the human breast”. We all believe that we are able of identifying winners for our stock investment portfolio. Of course, we will be able to do it from time to time. The question is, can we do it consistently over time, and in a large enough amount to make it economically worthwhile?

Needless to say, this research result will not settle the debate about active versus passive investing, or stock picking versus index investing. Active, stock pickers will still continue to ply their trade. For everyone else, there is index investing.