Average Stock Return: Why Diversify?

Investors often grapple with an investing paradox. While the stock market is a fantastic place to grow wealth, most individual stocks are not. The phenomenon of the average stock return can be puzzling. But understanding it is crucial for developing a successful investment strategy. Think you already know everything about the stock market? Take a break from reading this post and put your knowledge to the test with our free financial literacy quiz!

Back to what we were saying. The key phrase “why most stocks are bad investments, but the stock market is still a great place to invest” encapsulates this paradox and guides us toward a diversified, long-term investment approach as this post will describe.

Why Do Most Individual Stocks Fall Short of the Average Stock Return?

Some investors mistakenly believe that picking a few random stocks will yield the market’s average rate of return, typically around 7% per year after inflation. This assumption is flawed both empirically and theoretically. Suppose there is an equal probability that a stock will go up 10% or down 10% each period. Over multiple periods, the average result for individual stocks can vary widely, but mostly underperform the market average due to compounding losses.

Consider this simple example:

• Initial Investment: $100
• Probability of Increase: 50% (Stock goes up by 10% to $110)
• Probability of Decrease: 50% (Stock goes down by 10% to $90)

Ok, no surprises here. But, once we consider multiple periods, the math starts to look a lot less intuitive.

Let’s examine two possible scenarios after two periods (an up then down, or a down then up):

1. Stock increases then decreases:
   • After 1st Period: $100 * 1.10 = $110
   • After 2nd Period: $110 * 0.90 = $99
2. Stock decreases then increases:
   • After 1st Period: $100 * 0.90 = $90
   • After 2nd Period: $90 * 1.10 = $99

In both scenarios, the final amount is $99, not the expected $100 (original investment). The result is amplified as more time periods are considered.

Average Stock Return: Long-Term Performance

Following this simple example, Henrik Bessembinder of Arizona State University provides compelling real world evidence of this phenomenon in his paper “Do Stocks Outperform T-Bills?” He found that slightly more than half of common stocks since 1926 have positive lifetime returns, but only about one-quarter beat Treasury bills. While 50.8% of single-stock strategies generated a positive 90-year return, the median return was just 9.5%, compared to a 1,928% return on Treasury bills over the same time-frame. In fact, only 27.5% of single-stock strategies produced better returns than one-month Treasury bills. Tellingly, a mere 4% of stocks outperformed the value-weighted market.

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Insights from J.P. Morgan’s Study

J.P. Morgan’s study on the Russell 3000 index from 1980 to 2020 supports these findings. The median stock had a return between 0% and -10% most of the time, including reinvested dividends. This highlights how individual stock performance is often disappointing compared to the overall market.

Understanding Geometric Brownian Motion

Even if stock prices followed a perfectly symmetric percentage change, known as geometric Brownian motion, the average stock would still underperform. This is due to the compounding effect of gains and losses.

So, why does the stock market as a whole perform better than most individual stocks?

Diversification is Key

The conclusion from these studies is clear: broad diversification is essential for approximating the superior returns that stocks have historically offered. Diversification spreads risk across many stocks, capturing the overall market return. A narrow portfolio might yield significant gains, but it usually leads to underperformance and higher risk.

Understanding how to effectively diversify your investments can be complex. If you have questions about creating a diversified portfolio or need personalized investment advice, please feel free to contact us! Or, fill out our assessment questionnaire to find out if family office services can help you efficiently manage your wealth.

Let Your Profits Run: Best Practices for Long-Term Investment Success

As the pareto principle suggests, most of the returns from the stock market are due to a small number of stocks that greatly outperform. So, investors who want to capture market returns need to ensure they capture the returns of these great stocks.

And the main reason why many novice investors fail to match market returns is by selling their winning investments too soon. This is due to investor psychology, but the result is they never fully capture the returns of the small number of great stocks dragging up overall market returns.

A better strategy to capturing the market rate of return is to follow the old investing adage: “cut your losses short, and let your profits run”. Letting your best investments work their magic without selling them is the only way to match the market rate of return. Even if most of your stocks turn out to be losers, the great ones will make up for those losses (and more).

Average Stock Return or Stock Market Return?

Understanding why most stocks are bad investments but the stock market is still a great place to invest is a crucial lesson for investors. Individual stocks often underperform due to volatility and compounding losses. However, by embracing broad diversification and a long-term investment approach, investors can mitigate these risks and capture the market’s overall growth.

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