Cecil Bohanon and John Horowitz: Picking individual stocks is a fool’s errand

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Financial experts often recommend buying and holding a diversified portfolio of assets to build and maintain personal wealth. One of the most important reasons for a diversified portfolio is that the stock market gains come from a few firms. Stock market returns from most firms don’t do as well as investing in Treasury bills.

A recent study found that, from 1926 to 2019, holding most U.S. publicly traded common stocks reduced investor wealth. Moreover, the top 83 firms out of the 26,168 in U.S. stock markets account for half of the stock market’s wealth creation. Most wealth creation occurred in a few industries: technology, telecommunications, energy, health care and pharmaceuticals.

In another paper, the authors examined how nearly 64,000 global common stocks performed compared to U.S. Treasury bills from 1990 to 2020. Fifty-five percent of U.S. stocks and 57% of non-U.S. stocks had lower compound returns than U.S. Treasury bills. During the same period, the best-performing 2.4% of companies accounted for nearly all net global stock market wealth creation.

Another recent paper showed that while most stock market gains come from “star firms,” such companies didn’t generate extraordinary stock market returns by using their market power to restrict competition. They developed more valuable innovations.

In other words, wealth creation usually comes from better products and more efficient technologies rather than lobbying. However, the pharmaceutical companies did receive much of their wealth through patent protection of their new drugs.

The non-linearity of these results reminds us of the 19th-century social scientist Vilfred Pareto’s finding that Italy’s richest 20% of the population owned 80% of the wealth. This observation became the famous 80/20 rule that 80% of outcomes are due to 20% of the causes.

The 80/20 principle has been applied to many events and activities, including quality control, rainfall and volunteer contributions to not-for-profit entities. However, the non-linearity of these stock market returns is that not just 20% of stocks created 80% of the returns but less than 5% created all or nearly all of the stock market returns.

What is the takeaway for the average person? Trying to pick individual stocks for the average person is a fool’s errand, like trying to find a needle in a haystack. One is much better advised to invest in a broad portfolio of individual stocks, a mutual fund, or market-index funds. The stock market is not exactly a lottery, but one is well advised to buy many different tickets.•

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Bohanon and Horowitz are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.

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