Are most stocks a loser's bet?

According to a recent Money magazine article, a study from Dimensional Fund Advisors concluded that a mere 25% of the stocks in the U.S. market were responsible for all the gains from 1980 to 2008.

While the U.S. market as a whole generated a 10.4% annualized return, take out these "superstocks" (Money's term), and the remaining 75% of stocks actually generated an annualized loss of 2.1% over these 28 years.

That's right: Three-quarters of U.S. stocks lost value.

And that abundance of market losers actually makes sense -- just look at your local strip mall. As the likes of Wal-Mart (NYSE: WMT), Best Buy (NYSE: BBY) and Home Depot (NYSE: HD) eat up real estate and market share, smaller businesses struggle just to maintain a foothold. Many disappear. It's the nature of a free-market economy (unless you get bailed out by Uncle Sam -- but I digress).

Winning some, losing some
The study goes a long way toward explaining why most investors and mutual fund managers fail to beat the averages. With 75% of stocks losing money, even a skillful stock selector faces formidable odds.

That's why we at The Motley Fool have been saying for years that investors should park at least some of their portfolios in passive index funds. By tracking large baskets of stocks, these funds mirror the market’s overall return, mitigating the 75% of losers with the 25% that outperform.

The S&P 500 index, for example, gained an average of approximately 8% a year between 1980 and 2008. Being invested in a low-cost index fund would have given you excellent returns, without the risk of choosing individual stocks.

But the two decades between 1980 and 2000 were some of the best the stock market has ever seen, and since then the overall market has trended down (despite some spectacular bubbles along the way).

If you want to make money in more challenging markets -- like the one we're facing now -- you need to add timely individual stock selections to boost your returns.

And that means learning to tell the outperforming Amazon.coms (Nasdaq: AMZN) from the underperforming Overstock.coms (Nasdaq: OSTK).

Finding the gold among the dross
Some of the most important characteristics to seek when buying individual stocks include:

  • A sustainable competitive advantage that protects the company’s profits, be it patents, dominant market share, ownership of natural resources or network effects.
  • A reasonable start price -- if you overpay, it could be as bad as buying a losing business.
  • A management ethos that anticipates and adapts to change.

That last point is key. Johnson & Johnson (NYSE: JNJ), for instance, started 1980 at a split-adjusted $1.66 per share. Today’s $56 price tag turned a $10,000 investment in 1980 into more than $335,000 now, and that’s before earning or reinvesting a healthy dividend.

On the other hand, Eastman Kodak (NYSE: EK), an equally respected company in 1980, started that year at $21.42. Today, it’s below $3. After three decades of exhibiting patience, you’d have lost most of your money.

Over 30 years, $10,000 either became $335,000 or it became $1,400. A key difference between the two? The ability to adapt.

Technology changed beneath Eastman Kodak’s feet, and it didn't adapt to the challenges of the Internet and digital photography in time. The landscape changed many times on Johnson & Johnson, too, but management found ways to respond and capitalize -- it anticipated changes and adapted, making key acquisitions and evolving its product lines.

You need to adapt, too
Notice that our key criteria involve investing in the best businesses -- not trading shares month-in and month-out. If you want to outperform, you need to hold core positions for the long term. When buying at good prices, it’s only by owning superior companies over many years that you’ll compound your invested dollars.

In a volatile market like this one, that challenge can seem insurmountable. But there are sensible ways to make money in flat, down, and sideways markets, too -- ways that provide nearer-term income, complement your core stock holdings, and make it much easier to wait for them to flower.

Options are an excellent -- and even low-risk -- tool for producing steady income on flat or down stocks, rather than merely relying on a stock to go up. And using counter-market exchange-trade funds (ETFs), along with other sensible shorting strategies, can help you to profit on some of those 75% of stocks that ultimately lose money. After all, why pretend stocks only go up?

Even Warren Buffett, the consummate long-term investor, adapts, using options and more sophisticated tools to help tilt the odds in his favor.

Combining long-term investing with strategies like options and ETFs to make money in any market is what our new Motley Fool Pro service is all about. We’re a young service, but since October we’ve produced positive and market-beating returns on more than 80% of our few dozen positions, including both stocks and options.

To keep our membership manageable, Pro opens to new members for only a few days in June -- and we won’t reopen again until at least 2010. If you'd like to learn more about Motley Fool Pro, just enter your email in the box below.

Jeff Fischer is advisor to Motley Fool Pro. and Best Buy are Motley Fool Stock Advisor selections. Johnson & Johnson is an Income Investor pick. Best Buy, Home Depot, and Wal-Mart are Inside Value selections. The Motley Fool owns shares of Best Buy. The Motley Fool has a disclosure policy.