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, IBM, and Target, there are dozens of Rainforest Cafes, Lucents and Pets.com (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 Netflixes from the Overstock.coms.
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 -- think Wal-Mart's
(NYSE: WMT) scale and distribution network that provide it enormous cost advantages. - A reasonable start price -- if you overpay, it could be as bad as buying a losing business. Cisco Systems
(Nasdaq: CSCO) not only has a strong competitive advantage, but it's also trading at a reasonable price. - A management ethos that welcomes, anticipates, and adapts to change -- think Apple's
(Nasdaq: AAPL) well-timed moves into MP3 players and smartphones.
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
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.
The other side of the coin
But what if you want to profit, not only from the long-term winners, but also the losers? After all, the study discussed in Money suggests that the majority of stocks lose money -- profiting from losing stocks by shorting them makes sense.
Here, you want to focus on the opposite qualities -- a company that operates under a competitive disadvantage, that trades at an outrageous price, and is run by a management team more interested in manipulating the numbers than in adapting to a changing environment.
Given the numbers mentioned in Money, it can make sense to put the odds in your favor by setting aside a chunk of your portfolio for shorting stocks that bear these characteristics. That can act as a useful hedge against your favorite long positions, add stability to your portfolio, and possibly win big gains on that majority of stocks that would otherwise be money losers.
If you are looking to short individual stocks for big gains, enter your email address in the box below. I'll send you "5 Red Flags -- How to Find the BIG Short," a brand new report by John Del Vecchio, CFA, a leading forensic accountant, free right now to start you on your way.
