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 1983-2007 (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.
• 18.5% of stocks lost at least 75% of their value. Almost one in five stocks 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 the greatest bull market in history, the average U.S. stock 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 1983-2007.

How hard is it to find a 20%-per-year winner? Of the 6,007 stocks on the major U.S. exchanges, exactly 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 in that magical 248:

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. Because of that, the chance your stock portfolio made you any money  over the last decade was also just that, slim to none.

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

Look back at that table of the past decade's big winners above. 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 650 million iPhones over the next 10 years.
• Goldcorp's gold production would have to increase by 12 times (not happening) or the price of gold would need to rise to $14,200 (possible, but let's get real).
• Hansen Natural would need to sell $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, or about six times Starbucks' current annual sales!

Just look at a few of the big winners from 1983-2007 in Blackstar's study: American International Group, Bear Stearns, Citigroup, Fannie Mae, and General Motors. After 2007, one went bankrupt, while the other four each lost more than 90% of their value.

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

Stop trying to find winners
If this data suggest to you that picking individual stocks is a sucker's game, I don't blame you. 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.

The key is to stop spending so much fruitless time looking for them. Instead, let's put the odds in our favor and focus on the 64% of stocks that just plain stink. We may even come across some of the really ugly ones -- the 20% of 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 frankly, I'd be out of a job.

Instead, I suggest that you set aside a good chunk of your portfolio for shorts. That will act as a useful hedge against your favorite long positions, and give your portfolio a lot of critical ballast during tough times in the market.

That's the approach Matthew Richey and John Del Vecchio will be taking with Motley Fool Alpha -- the Fool's first hedge-fund-style service, which aims for serious profits in both up and down markets. A small group of investors will be invited to join. If you'd like to hear more as details come available, click here.

This article was originally published on Aug. 10, 2010. It has been updated.

Matthew Argersinger doesn't own any of the stocks mentioned in this article. Green Mountain Coffee Roasters and Hansen Natural are Motley Fool Rule Breakers recommendations. Apple and Quality Systems are Motley Fool Stock Advisor selections. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.