There is a common temptation to try to get rich by picking the next hot stock in hopes of retiring early, or at the very least achieving impressive returns. While the idea of being the next Warren Buffett is alluring, sound investment strategy for the average person is a lot less interesting. If you are looking for a strategy on how to pick stocks for long term gains, it is probably best that you don’t gamble with your retirement money.
Most know they are supposed to lose when they play at a casino, yet they play anyway in hopes they will “beat the odds”. Believe it or not, attempting to pick individual stocks that beat the average return of the market is not much different than gambling.
There are a lot of sites out there that sell “the secret” to picking stocks. It is probably wise to steer clear. Here is why.
Most Stocks Turn Out to Be Duds
Hendrik Bessembinder from Arizona State University wrote a paper (Do Stocks Outperform Treasury Bills?, 2017), which was the result of a study he conducted on all common stocks listed on the New York Stock Exchange, NASDAQ, and Amex during the period 1926 to 2016. It came up with some fairly discouraging results for stock pickers.
- Less than half of stocks (47.92%) beat the same month Treasury Bill return.
- Less than half of the stocks studied produced positive returns.
- Over the long term, only 42.6% of those stocks studied beat the T-bill (including dividend reinvestment).
- More than half produced losses.
- The most common outcome for stocks over this period was for them to result in a total loss.
Note: Treasury Bills are short term low risk and low yield investments. For a stock not to beat a T-Bill indicates very poor performance of a stock given the risk of equities compared to the T-Bill. T-bills are technically considered “risk free” because they are backed by the US Federal government.
The following part of the research is perhaps the most damning against stock pickers. Of 25,300 companies that were studied during that period.
- 5 of the companies were responsible for 10% of what Bessembinder refers to “wealth creation”, or returns that exceeded the T-Bill.
- 90 companies were responsible for 50% of wealth creation.
- 1,092 of the top producing companies contributed to all of the wealth creation. That is only 4.32% of all studied companies.
What Do These Numbers Mean?
If you research average stock market returns, you will typically find figures ranging from 7-10% annual returns. This depends on the methods used to calculate the returns, the time period of focus, as well as the collection of stocks that are used. However, the data from reports like the one referenced in this article reveals that most of the positive returns come from a relatively small number of companies.
This also means the individual returns of the winners are so significant that they offset the losses of the rest and still manage to produce 7-10% returns.
Could you pick the top stocks? It’s possible, but it’s extremely unlikely for the average investor. It’s essentially gambling for the average person.
So what should the average investor do?
Consider the Advice of Warren Buffett
If you are trying to find out how to pick stocks like warren Buffett, you are probably better off taking his advice for ordinary investors. In a 2018 interview on CNBC, Warren Buffett offered short and sweet advice for the average investor.
“The trick is not to pick the right company. The trick is to essentially buy all the big companies through the S&P 500.” He also recommends to only invest in low cost index funds.
“Costs really matter in investments…If returns are going to be 7 or 8 percent and you’re paying 1 percent for fees, that makes an enormous difference in how much money you’re going to have in retirement.”
Does the average investor have better odds stock picking than playing casino games? Probably.
Is stock picking still gambling? Yes.
Let’s face it, a responsible investment strategy is largely boring, but investing isn’t about entertainment, it is about saving and growing that investment for your future goals. Whether it be to buy a home, send your kids to college, and/or obtain financial independence.
I have a finance degree which teaches various valuation models to evaluate the value of equities and other assets. I know how to read financial statements, etc. However, I still do not stock pick as an investment strategy. I know I am unlikely to beat the market even with my finance knowledge.
At the end of the day, for most of us, boring investing is smart investing.