What Big Winning Stocks Have In Common

If you want to pick stocks that outperform the averages or develop a greater understanding of trend-following risk management techniques for your equity portfolio then this post by Mebane Faber at World Beta highlighting research by Eric Crittenden and Cole Wilcox from Blackstar Funds is a must read. It is unusual material not found elsewhere. Specifically, you will learn…

How 2 out of every 5 stocks lose money over time.
How nearly 1 out of every 5 stocks loses 75% or more of their value.
How nearly 2 out of every 3 stocks under-performs the index averages.
And most importantly… how a very small minority of stocks account for much of the gain in the averages.
Specifically, the top 25% of stocks accounted for all of the gain in the Russell 3000 from 1983 to 2007.
In other words, the other 75% of stocks contributed zero performance during one of the greatest bull markets in recorded history.
Amazingly, the average annual return from all stocks in the Russell 3000 from 1983 to 2007 was actually negative even though the index posted a positive performance (this is due to survivorship bias and capitalization weighting in index construction).

Needless to say, these are startling statistics in a world taught to buy, hold and pray a diversified equity portfolio. This is research you won’t find in the waiting room at your brokers office because the implications for investment strategy are dramatic.

The research also points out a very simple, common-sense characteristic that all the big winning stocks share in common. Knowing this single characteristic can tell you immediately whether you portfolio is filled with the 25% of stocks driving the markets gains, or the other 75% that is making no contribution at all.

So which stocks are you holding in your portfolio – the winners or the losers? How do you know? I don’t want to steal the punch line because the research is well worth your time so go over to Mebane’s post and learn for yourself. It’s great stuff.

Adding my own viewpoint, what’s important about this unique research is how it looks “under the hood” of the index averages and dissects their performance into component parts to yield little known but important information. What’s divulged is how certain eternal truths apply to individual stock selection just as they apply to life or building wealth. For example…

Pareto’s Law teaches how 80% of your results come from 20% of your efforts. I’ve found this true in my own life as well as business and investing, and it has also been true for my coaching clients. Now we have research showing it is equally true when examining stock market winners because it is a basic truth of life. The bulk of the any stock index average’s performance comes from a tiny selection of stocks just as the bulk of the results in your life can be attributed to just a few key decisions. Focusing on getting those few key stocks or key decisions right can make or break your success.
Trend-following as a risk management discipline works regardless of which trading vehicle you apply it to. It doesn’t matter whether it is mutual funds, ETFs, commodity futures, or (in this case) individual stocks. Similarly, the concept is equally valid in managing your life, relationships, and health. The reason is simple: trend-following when applied correctly limits downside volatility and risk. It is a basic mathematical truth that must always be adhered to - you must always manage your risk of loss to acceptable levels. This helps keep you portfolio and life on a positive track so that you consistently achieve higher highs and higher lows – and that is as good as it gets in this world.
Finally, fat-tailed, non-normal distributions are investment and life reality. Academia teaches normal distributions but the mathematical evidence disagrees. It is the flip-side to the trend-following argument made above that statistically proves why risk management is an essential portfolio and life management discipline. It provides the statistical backbone showing empirically why these principles work in practice and the problems they solve (avoiding fat-tailed losses).

Hopefully I didn’t get too philosophical here but my passion for the investment game extends not just to principles of financial freedom but also to the personal freedom these same truths can teach. After all, there is more to freedom than just financial. Happiness is the real goal, and these principles are just as applicable to life as they are to investing.

I hope you find the research as thought provoking and informative as I did.

This post is part of my “Best of the Web” series where I will periodically bring to your attention outstanding research and educational content found throughout the web that can help you manage your portfolio, build wealth and enjoy financial freedom. If you found this post helpful please spread the word.