Forget Buy and Hold, Think Buy and Short

I'm going to let you in on a little secret. Most stocks stink.

And I'm not just talking about my personal portfolio, though I've owned plenty of terrible stocks in my life. No, most stocks really do stink.

In fact, nearly two-thirds of stocks will underperform a diversified index. That's according to a research study by hedge fund Blackstar Funds covering stocks traded on all three major U.S. exchanges from 1983-2006 (a very bullish period for the stock market).

What did Blackstar find?

• 64% of stocks underperformed the Russell 3000 during that span, dividends included.
• 39% of stocks had a negative lifetime total return. Two out of every five stocks lose money.
• 19% of stocks lost at least 75% of their value. Almost one out of five is a really bad investment.

What's more, the mean compounded annual return of the 8,054 stocks in Blackstar's study was -1.06%. Think about that for a second. In what was considered a bullish time for stock returns, U.S. stocks on average actually lost money.

Nope, no silver lining here
Here's where you're probably expecting me to say: "But ignore all these bad statistics. You and I, we can find winning stocks. No problem!"

I hate to break it to you, but only a small sliver of stocks -- 14% to be exact -- delivered compound annual returns of greater than 20% during the period covered in Blackstar's study. That small cohort was responsible for almost all of the gains of the Russell 3000 from 1983-2006.

How hard is it to find a 20% per year winner? Of the 5,869 stocks on major U.S. exchanges, only 248, or about 4% of them, had compounded annual returns of 20% or more over the last 10 years.

Let's take a look at few of the big winners:

Data from Yahoo! Finance and Capital IQ, a division of Standard & Poor's.

Granted, Apple was already a household name in 2000, but that was pre-iPod and iPhone, and competitors like Dell and Gateway were eating Apple's lunch in the personal computer market. If you were savvy enough to spot the gold trend before it really started to take off and ride Goldcorp to huge gains, more power to you. The other names on the list were all small companies back in 2000, and probably not on most investors' radars.

All of this is to say that, out of a large universe of nearly 6,000 stocks, the chance of having even minimal exposure to any of these 248 big winners was slim to none.

History hates winners
Let's go back even further. Imagine it were 1980 and I told you that in 30 years, Eastman Kodak, Bethlehem Steel, General Motors, Emery Air Freight, Polaroid, and Xerox would either be bankrupt or be trading for less than they were in 1980. You would have called me crazy. These were some of the leading companies of the day.

Look back at that table above of the past decade's big winners. Are Apple, Goldcorp, Hansen Natural and Middleby likely to repeat their great performance of the past decade?

• Apple would need to sell somewhere on the order of 1.2 billion iPhones over the next 10 years.
• Goldcorp's annual production would have to increase by 11 times (not happening) or the price of gold would need to rise to $13,100 (possible, but let's get real).
• Hansen Natural would need to work its way up to selling some $90 billion worth of its Monster beverages every year by 2020. That's three times Coke's current annual sales!
• Middleby would have to sell $11.2 billion worth of commercial ovens and equipment. How many restaurants are there in the U.S.?
• Green Mountain Coffee roasters would need to sell $65 billion worth of coffee machines and coffee every year by 2020, more than six times Starbucks' current annual sales!

Just look at a few of the big winners from 1983-2006 in Blackstar's study: American International Group (NYSE: AIG), Bear Stearns, Citigroup (NYSE: C), Fannie Mae, and General Motors. Since then, one of those companies went bankrupt (GM), another was put into receivership (Fannie), while the other three each lost more than 90% of their value. Bear Stearns was bought out by JPMorgan for a fraction of its previous value, and there's still a very real chance that AIG and Citigroup face further losses. AIG still owes the U.S. government $102 billion for its massive bailout and any cash it can squeeze from asset sales and its beleaguered insurance operations may not be enough to cover the deficit. Citigroup's above-average exposure to consumer banking makes it extremely vulnerable to more pain in the housing market and new restrictions on consumer credit thanks to the financial reform act.

Big winners. Now big losers. Kind of makes you question the pure 'buy and hold' approach, doesn't it?

Stop trying to find winners
How many of us are actually smart enough and lucky enough to find those 4% of stocks that will turn out to be big winners? Very few. In fact, you'd be very fortunate to just find one long-term 20% winner in your lifetime.

So we shouldn't spend so much of our time looking for big winners. Instead, let's put the odds in our favor and focus on the 64% of stocks that stink. We may even come across some of the really ugly ones -- the  one out of five stocks that will go on to lose 75% of their value. Heck, the odds of finding a big loser are almost five times the odds of finding a big winner!

Now, I'm not suggesting you dump all of your long positions and just start shorting stocks. After all, if there weren't great returns to be made buying individual stocks, we'd all stand to make a lot less money and … well, I'd be out of a job.

What I'm suggesting is that you set aside a chunk of your portfolio for shorts. That will act as a useful hedge against your favorite long positions and give your portfolio a critical ballast during tough times in the market. Just imagine if 20% of your portfolio would have been short going into the 2008 market crash. Imagine how much better we all could have done.

If you are looking to short individual stocks for big gains, enter your email in the box below. I'll also send you our latest research the instant it is published plus I'll send you a brand new report, "5 Red Flags -- How to Find the BIG Short," free right now.