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A trader works on the floor of the New York Stock Exchange (NYSE) under a screen displaying share prices of Ford, Eli Lilly, Pfizer and UPS on May 15. (Brendan McDermid/Reuters)
A trader works on the floor of the New York Stock Exchange (NYSE) under a screen displaying share prices of Ford, Eli Lilly, Pfizer and UPS on May 15. (Brendan McDermid/Reuters)

Hot stocks can make you rich, but they probably won’t Add to ...

Individual stocks can be hazardous to your financial health.

You may not want to hear that right now, with the stock market regularly hitting new highs.

The Standard & Poor’s 500-stock index set another record Wednesday after reaching a new high Monday. It set records on two days the previous week, too. Counting dividends, it has returned more than 6 per cent this year and more than 15 per cent in the past 12 months.

What’s more, big bets on hot stocks are generating enormous gains. This year, for example, two companies in the S&P 500 — biotechnology company Vertex Pharmaceuticals and video game developer Activision Blizzard — have each returned more than 50 per cent to their fortunate shareholders. No question about it, if you pick a sizzling stock at just the right time, you can become rich. Some stock pickers have done well over long periods, too.

But before you jump headlong into stock picking, you may want to consider the odds. It’s not just that bull markets like this one eventually come to an end. It’s that over the long run, while the total stock market has prospered, most individual stocks have not.

A new study by Hendrik Bessembinder, a finance professor at Arizona State University, demonstrates persuasively that while investing in the overall stock market makes sense, the obstacles facing individual stock pickers are formidable. It’s much less risky to invest with diversified low-cost mutual funds.

In a working paper with the provocative title “Do Stocks Outperform Treasury Bills?” Mr. Bessembinder found that individual stocks resemble lottery tickets: A very small percentage of winning stocks have done splendidly, but when gains and losses are tallied up over their lifetimes, most stocks haven’t earned any money at all.

What’s more, 58 per cent of individual stocks since 1926 have failed to outperform one-month Treasury bills over their lifetimes, he found. That is a low bar, given the piddling returns on one-month Treasury bills, which now yield less than 1 per cent.

Mr. Bessembinder found that a mere 4 per cent of the stocks in the entire market — headed by Exxon Mobil and followed by Apple, General Electric, Microsoft and IBM — accounted for all of the net market returns from 1926 through 2015. By contrast, the most common single result for an individual stock over that period was a return of nearly negative 100 per cent — almost a total loss.

All that gloom about individual stocks may seem counterintuitive. After all, it’s often said that stocks outperform bonds over the long haul. That’s why long-term investors are generally advised to hold stocks in their portfolios.

The problem is that the rosy long-term outlook for stocks, as opposed to bonds, is based entirely on the big picture. When you look more closely, the details are disconcerting.

Using a database developed at the University of Chicago, known as CRSP, for the Center for Research in Security Prices, Bessembinder surveyed virtually every stock listed on the broad American market from July 1926 through December 2015. He compared their returns with those of one-month Treasury bills over periods as short as one month and as long as that entire stretch.

Viewed as single units, Mr. Bessembinder found, the typical stock does not outperform Treasury bills. Yet taken as a whole, the overall stock market certainly does beat bonds and Treasury bills by very wide margins.

Data posted by Aswath Damodaran, a New York University finance professor, for example, shows that since 1928, stocks returned about 9.5 percent, annualized, compared with only 4.9 per cent for 10-year Treasury bonds and 3.5 percent for three-month Treasury bills. In that horse race, stocks won by a mile.

“Many studies have shown that stocks outperform bonds overall, and I don’t question that data at all,” he said in an interview.

How can those two sets of facts — the underperformance of the typical stock and the outperformance of the overall stock market — both be correct?

It is because a relative handful of stocks tend to outperform all others by tremendous amounts.

There is a technical explanation for this. Bear with me. In the language of statistics, the stock market generally has a positive skew — meaning, a relatively small number of outliers like Exxon or Apple have such great returns that they pull up the average stock, which has a mediocre showing. Put another way, the average return is higher than the median or typical return.

What does all of this mean for investors?

It does not imply that stock picking can’t be successful or that it’s wrong for those who do it with their eyes wide open.

“Some people who pick the right stocks can have lottery-like returns,” Mr. Bessembinder said. “They may want to take that risk and do that.”

But it does imply that most people picking stocks are unlikely to do well for very long.

In response to a question, Mr. Bessembinder said he, personally, favors low-cost index mutual fund investing, through which he maintains a widely diversified portfolio of bonds and stocks.

That is a less risky strategy — though investing in stocks always involves risks, perhaps especially in a period like this one, when stocks have been rising for a long while. And it’s not a revolutionary approach by any means. It won’t produce the stratospheric returns that are possible if you are able to pick the one stock that will outperform all others for the next several decades.

“There’s a good chance that it will be a stock that we haven’t even heard of,” Mr. Bessembinder said.

If you are confident you can identify that stock, good for you. I’m sticking with dull, diversified mutual funds because I know I can’t.

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