Are most stocks a loser's bet?

According to a 2009 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%, on average, over these 28 years.

And that abundance of market laggards actually makes sense -- just consider the relatively few companies that have ongoing relevance in our lives, compared to the thousands that just... don't. For every Starbucks (NASDAQ:SBUX), IBM (NYSE:IBM) and Target (NYSE:TGT), there are dozens of Rainforest Cafes, Lucents and (remember the sock puppet?) As the strong get stronger, thousands of smaller businesses struggle to maintain a foothold. Many disappear, taking shareholder value into the grave.

Winning some, losing some
The study goes a long way toward explaining why most mutual fund managers fail to beat the S&P 500's return. With 75% of stocks losing money in aggregate the last 28 years, 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 greatly outperform.

The S&P 500 index, for example, gained an average of 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 even the mighty indexes have fallen -- last month, the S&P ended the decade with its worst 10-year performance since the Great Depression, down 23% (down 8% including reinvested dividends).

If you want to make money in today's more challenging market, you need to add timely individual stock selections to boost your returns.

And that means learning to discern before everyone else the outperforming Netflixes (NASDAQ:NFLX) (up more than 500% since 2002) from the underperforming Overstock.coms (NASDAQ:OSTK) (flat since 2002).

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 market share, patents, 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 welcomes, anticipates, and adapts to change.

That last point is key. If you had to make only one investment for the next 10 years, and your choices were limited to either Google (NASDAQ:GOOG) or Microsoft (NASDAQ:MSFT), which one would you buy? Google is intent on redefining the online computing experience, while Microsoft is devoted to sustaining its cash cow products. The company with a vested interest in keeping customer habits from changing (Microsoft) is at a long-term disadvantage to the company that's working to improve the computing experience for everyone (Google).

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.

Once you accept that your core stock holdings must be long term, you can open your eyes to the fact that there are many other sensible ways to make money in flat, down, and sideways markets -- ways that provide near-term income, complement your core stock holdings, and make it much easier to wait for your stocks 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 the market to go up. And using counter-market exchange-trade funds (ETFs), along with other lower-risk shorting strategies including options, can help you to profit on the majority of stocks that ultimately lose value. 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. He's done so for decades, and at the same time he's been a long-term holder of his stocks.

Combining long-term investing with strategies like options and ETFs to make money in any market is what our Motley Fool Pro service is all about. Since launching in October 2008, we've produced gains on more than 92% of our several dozen positions, including both stocks and options.

To keep membership manageable, Pro hasn't been open to new members since June of 2009 – but it will open again for a few days this month. If you'd like to learn more about Motley Fool Pro, just enter your email in the box below.

This article originally ran June 12, 2009. It has been updated for today.

Jeff Fischer is the advisor of Motley Fool Pro, a real-money portfolio of stocks, options and ETFs. Jeff owns shares of Google, which is also a Rule Breakers recommendation. Microsoft is a Motley Fool Inside Value selection. Netflix and Starbucks are Motley Fool Stock Advisor selections. Motley Fool Options recommends a diagonal call strategy on Microsoft. The Fool has a disclosure policy.