Financial Planning Blog

William Bernstein, author of The Four Pillars of Investing, The Intelligent Asset Allocator, and a couple of other financial books, is highly respected among knowledgeable, passive investors. He is the co-founder of Efficient Frontier Advisors, has a PhD in Chemistry from U.C. Berkeley, and until recently was a practicing neurologist in North Bend, Oregon. (OK, but what has he done lately?)

In a CNN/Money article entitled "Are Stocks a Loser's Bet?" Bernstein points out some startling stock market statistics that are worth considering carefully. Apparently, the top performing 25% of stocks are responsible for all of the gains in the broad U.S. market from 1980-2008, while the other 75% of stocks were actually generating loses. According to the research from Dimensional Fund Advisors, the bottom 75% of the stock market sustained annual losses of -2.1%, but the stellar performance of the top 25% pulled the overall market return up to 10.4% per year. Talk about carrying the team--these top stocks had to seriously outperform.

To many the obvious conclusion from all of this is to just select from the top 25% of stocks and leave the losers to the less enlightened. Unfortunately, this is a great strategy that you will most likely fail to execute successfully. In fact, you take the very real risk of missing out on many of the winning stocks, and underperforming the market. If you happened to have the misfortune of missing the top performing 10% of stocks during this period, your portfolio returns dropped from the 10.4% to just 6.6% annually. That turns out to be some serious money when compounded over 29 years.

Larry Swedroe, in What Wall Street Doesn't Want You to Know, talks about this same phenomenon in the context of small cap stocks. He references a 1997 study by Peter Knez and Mark Ready that investigated the higher returns of small cap stocks over large cap stocks. It turns out that the excess returns of small cap companies comes from a very small number of stocks. Apparently, if you remove the top performing 1% of small stocks on a monthly basis, the excess return from small stocks more than disappears. They referred to this as the "turtle egg" effect--where many turtle eggs are laid, but only a few will survive and make it to the ocean. Swedroe's conclusion was not to waste money trying to identify the few winning turtle eggs from the thousands of small cap stocks and buy the entire market through a low cost index fund.

Bernstein's suggestion is to cast a wide net so you don't take a chance on missing those top performing stocks. Sure you get the mediocre ones and the dogs, but don't underestimate how difficult it is to indentify which is which beforehand. By buying the whole market you are assured to get the overall market returns. He reminds us, "Remember that the point of investing isn't to aim for the highest possible returns. It's to make sure you don't die poor." I'm sure there are some who don't agree with that statement, but the rest of us should remember what our real goals are and invest accordingly.