While we’ve all come to understand the benefits of diversification when investing in U.S. equities, one economist, Hendrik Bessembinder at Arizona State University, has greatly contributed to our understanding of diversification, as well as the distribution of returns.

In 2021, he published a study in the Journal of Investing called “Wealth Creation in the U.S. Public Stock Markets 1926-2019.” Here he analyzed the long-run stock market outcomes, measuring the increases or decreases in shareholder wealth creation (relative to a benchmark of T-bills). In his analysis, he looked at the full history of both net cash distributions and capital appreciation. His data included all the 26,168 firms that had issued publicly traded U.S. common stock since 1926.

In calculating the change in net worth, he explicitly accounted for new share issuances, share repurchases, and the fact that dividends are not (in aggregate) reinvested in the stock market (share repurchases and dividends reduce market capitalization but do not decrease the calculated shareholder wealth creation).

Bessembinder made a number of key discoveries:

• A majority of stocks led to reduced rather than increased shareholder wealth.

• Aggregate shareholder wealth creation has been concentrated in a relatively few high-performing stocks.

• The 86 top-performing stocks, less than one-third of 1% of the total, collectively accounted for more than half the wealth creation. And the 1,000 top-performing stocks, less than 4% of the total, accounted for all the wealth creation. The other 96% of stocks just matched the return of riskless one-month Treasury bills!

• The degree to which stock market wealth creation has been concentrated in a few top-performing firms has increased over time and was particularly strong during the most recent three years of the study, when five companies accounted for 22% of net wealth creation.

• The concentration of shareholder wealth creation is attributable to the fact that the distribution of stock outcomes over the long term is positively skewed (positive skewness means distorted from the bell curve or normal distribution). Since most individual outcomes in a positively skewed distribution are less than the average outcome, this implies that undiversified portfolios selected at random will underperform the overall market more often than not. This understanding should reinforce the idea that low-cost, broadly diversified strategies are both desirable and prudent.

New Research
Bessembinder published another paper in July 2024 called “Which U.S. Stocks Generated the Highest Long-Term Returns?” This time he analyzed the returns of the 29,078 publicly listed common stocks contained in the CRSP database held by the Center for Research in Security Prices (at the University of Chicago’s Booth School of Business). He looked at the stocks from the period of 1926 to 2023.

In this paper, he made some new discoveries:

• On average, companies appeared in the CRSP data for only 11.6 years.

• The median lifespan of the companies in the database was just 6.8 years.

• Only 31 stocks were present in the database over the full 98-year period.

• Most of the companies (51.6%) had negative cumulative returns. Most of the stocks destroyed value.

• The median outcome was a return of negative 7.41% per annum.

• The mean compound return outcome was strongly positive, but the median outcome was negative. That difference, again, stems from the positive skewness in the distribution of compound stock returns.

• Even when the data was restricted to include only those stocks that had at least five years of history (but not more than 20) most of the stocks still produced negative returns.

• Even among the 30 stocks with the highest cumulative compound returns, the results were relatively modest. The median annualized return across the 30 stocks was 13.03%, while the mean was 13.05%. The largest return was Altria Group’s at 16.29%. How many investors would have guessed that one?

His findings led Bessembinder to conclude: “While very high annualized returns are observed in the historical data over relatively short periods, such dramatic returns have historically not been sustained over long intervals.” He added: “The highest annualized returns attained by any stock are systematically lower among those stocks with longer lives.”

Investor Takeaways
While investors have enjoyed a large excess return from the equity risk premium, a large majority of stocks have suffered a lower return than the investor would get for a risk-free asset. That shows just how much uncompensated risk is accepted by investors who buy individual stocks (or a small number of them)—risks that could be diversified away without reducing expected returns. Those investors considering active strategies—in hopes of taking advantage of a positive skew in outcomes—are likely accepting lower returns in exchange.

The historical record suggests that the net wealth creation/destruction attributable to the overall stock market in the future will be concentrated in a relatively few firms. That means active management is unlikely to benefit from that concentration, and that the winning strategy is to avoid active security selection or market timing.

Mistakes
Investors make mistakes when they take idiosyncratic, uncompensated risks. They do so because they are overconfident in their skills, they overestimate the worth of their information, they confuse the familiar with the safe, they have the illusion of being in control, they don’t understand how many individual stocks are needed to effectively reduce risks that could have been diversified, and they don’t understand the difference between compensated and uncompensated risks (some risks are uncompensated because investors could have diversified them). These mistakes help us explain why investors aren’t diversified. Another likely explanation for their actions (from the field of behavioral finance) is the preference many of them have for positive skewness—they are willing to accept the high likelihood of underperformance in return for the small likelihood of owning the next Google.

In other words, they like to buy lottery tickets.

If you have made any of these mistakes, you should do what all smart people do: Once they have learned that the behavior is a mistake, they correct it.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest, Enrich Your Future: The Keys to Successful Investing.