A common criticism of index funds is that they own losing stocks as well as winners. It’s true, they do. But does it actually matter?
Every investor loves a winning stock. As for losing stocks, most investors, given the choice, would avoid them like the plague. It’s perfectly natural that we should feel this way, both from a neurobiological and a behavioural perspective.
Winning stocks activate the brain’s reward system, releasing dopamine, a neurotransmitter associated with pleasure and reward. Losing stocks can induce the release of cortisol, a stress hormone, which often results in heightened anxiety and fear. Also, because of a bias called loss aversion, investors tend to experience the pain of losses more intensely than the pleasure of equivalent gains. But what if we told you that owning losing stocks is inevitable, and that coming to terms with that fact will help you to achieve your investment outcomes?
Most (yes, most) stocks are losers
Strange as it may seem, the vast majority of stocks are losing stocks. Yes, you read that correctly. A study by Professor Hendrik Bessembinder from the WP Carey School of Business at the University of Arizona, analysed the performance of more than 26,000 US stocks between 1926 and 2019. What he found was that, although the overall U.S. stock market has outperformed Treasury bills (or US government bonds) in the long run, most individual stocks have not. Specifically, less than half of the stocks he analysed generated positive lifetime returns, and only 42.6 percent outperformed one-month Treasury bills.
How, then, can we explain the fact that U.S. stock markets nevertheless delivered very positive returns to investors during that period? The answer, says Bessembinder, is that the market’s net gain was driven by a small percentage of highly successful stocks. Indeed, market returns were wholly driven by only the top four percent of companies.
In other words, Bessembinder’s research provides strong evidence of what statisticians call positive skew in the stock market. Simply put, the best-performing stocks have experienced outsized returns relative to the rest of the market.
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