“How” you invest in the stock market is a game of odds and likely will have a significant impact on portfolio returns over a lifetime of investing.
On one extreme, you can invest your money in one company, watch it like a hawk, and hope for the best. On the other extreme, you can own all the companies in a “Total Stock Market”-type index fund, ignore the market, and get on with your life.
Amid the two extremes are myriad other options, whether it be owning a portfolio of individually chosen stocks or trusting your dollars with a professional stock picker, employed by an actively managed mutual fund.
Most investors’ equity allocation falls somewhere in between the two extremes, especially with the notable performance and attention over the last decade to the FAANG stocks: Facebook, Amazon, Apple, Netflix, and Google (now trading as Alphabet).
Despite the popularity of FAANG stocks, I am convinced individual stock selection is a suboptimal way to approach ownership in this asset class. It is a game of odds.
Consider for a moment a stock market consisting of three stocks, each trading at $1/share, and you have $30 dollars to invest. Your local fortune-teller reveals that in 20 years, two companies will still be trading at $2, while the third stock will be trading at $1,000.
How would you invest your $30? Common sense says the optimal choice is to invest $10 in each stock.
This simple exercise is surprisingly close to how the stock market actually operates. Hendrik Bessembinder, finance professor at Arizona State University, studied the performance of almost every publicly traded company in the U.S. from 1926 to 2015, and found that 58 percent of these stocks underperformed one-month Treasury bills over the period. His research concluded that only 4 percent of stocks during that period, headed up by Exxon Mobil, Apple, General Electric, Microsoft and IBM, accounted for all the net market returns.
In short, the market has been, and will continue to be, driven by a small subset of stocks, and not including those stocks in your portfolio can be prohibitively expensive. Research by Dimensional Fund Advisors shows that, “Excluding the top 10 percent of performers each year from 1994 through 2018 would have reduced global market performance from 7.2 percent to 2.9 percent.”
FAANG stocks receive outsized attention by the financial media these days, but that is the case of hot stocks in any era. The top performing stocks of the 1980s included Hasbro, the Gap, and Toys R Us. The 1990s top picks included AOL, Cisco, and Clear Channel. Medifast, Green Mountain Coffee, and Clean Harbors were the leaders in the 2000s, and the past decade produced names like Netflix, Amazon.com, and Apple. One thing is “almost” certain. The top stocks of this decade will not be the top stocks of the next decade.
While it is possible to choose individual stocks that will generate lottery-like returns, the odds of accomplishing that are infinitesimally small, and the price paid is prohibitively expensive.
Instead of trying to identify the next decade’s top performers,
I suggest you own these companies by owning them all through a diversified portfolio of low-cost index and passively managed funds.