Why You Must Diversify: Very Few Stocks Outperform Government Bonds

Every individual looking to make their way in the world of investment has heard this fundamental piece of advice: "In the long run, stocks outperform safer assets like Treasury bills." It's called the Equity Risk Premium, and has become a time-honored axiom, an essential part of investment wisdom, and an underpinning of theories like the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory. But does this conventional wisdom hold water? Or, like many other traditional beliefs, does it need to be scrutinized and reevaluated?

This very question was taken up by finance scholar Hendrik Bessembinder in his landmark study, "Do Stocks Outperform Treasury Bills?" initially published in 2018. The results are a bit surprising.

Key Takeaways

• In aggregate, stocks do significantly outperform Treasuries.
• Individually, most stocks don't beat Treasury bills in the very long run.
• Only 4% of 'super-performer' stocks drive the wealth creation in the stock market.
• Picking 'super-performers' is tough; diversification is key.

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This study analyzed the performance of approximately 26,000 stocks over a long-term period from 1926 to 2015. Bessembinder compared each stock's lifetime performance to US Treasury bills, the definition of a risk-free investment. The results? A surprising majority of stocks (approximately 58%) failed to outperform one-month Treasury bills over their lifetime.

You read that right. More than half of all stocks in the study couldn't beat the return of the risk-free US Treasury bill. That is, investors in 58% of all stocks since 1926 received no incremental returns for having taking on the risk of investing in a private company versus investing in the US government.

While most stocks underperformed T-bills, there were some notable exceptions - a very small subset of 'super-performers'. The study found that, of course, in aggregate a diversified basket of all stocks did substantially outperform investing soley in US Treasuries - but - the entire wealth creation of the U.S. stock market over the study period was attributable to only about 4% of stocks. Without these few stars, such as industry giants like Apple and Amazon, the overall stock market would have actually underperformed Treasury bills.

So, while the average return of stocks as a whole may be higher than that of T-bills, this average is heavily skewed by a small number of super-performing stocks. Most individual stocks do not outperform T-bills; the positive skewness in stock returns is driven by a small group of 'lottery ticket' stocks that yield extraordinarily high returns.

These findings have profound implications for individual investors, and notably, they underscore the importance of diversification in investment portfolios. As it turns out, your chances of picking the few 'super-performer' stocks are quite slim. And without these 'super-performers', a portfolio of individual stocks is likely to underperform safer assets (literally risk-free!) like T-bills.

So, how can investors increase their chances of holding these exceptional stocks in their portfolio? The answer is diversification. By holding a large and diverse portfolio of stocks, you can increase the likelihood that your portfolio will include these rare, high-performing stocks.

This research challenges the long-standing belief that the 'average' stock outperforms safer assets and underscores the fact that 'average' returns are often skewed by the performance of a few outliers. The key takeaway for investors is not to bet all their money on a few stocks, hoping to hit the jackpot. Instead, focus on building a well-diversified portfolio that is more likely to include these 'lottery ticket' stocks.

With a well-diversified portfolio, investors are more likely to capture the returns of the rare 'super-performing' stocks that drive the overall performance of the stock market.

Remember, in investments there is no 'one-size-fits-all' strategy. Each investor's goals, risk tolerance, and time horizon will shape their optimal portfolio. However, as Bessembinder's study suggests, diversification remains a key factor in increasing the chances of successful investing.