Average is not the same as median…

The most read post I ever wrote showed that the distribution of stock market returns is not symmetrical around some average performance. Instead, the longer your time frame, the more asymmetrical market returns become. This is true of the market overall and of individual stocks as well. But if the distribution of individual stock returns is not symmetrical, the average return of stocks is different from the median return of stocks. And this difference is enormous.

Antti Petajisto analysed the return distribution of all US stocks in the CRSP database going back to 1926. Below is the distribution of returns for different investment horizons. Note that the distribution gets more and more skewed to the left as investment horizons increase and that the left-hand side of the distribution is not zero, but a total loss of investment (-100% return).

Distribution of individual stock returns

Source: Petajisto (2023).

This is not just the result of speculative companies in high growth sectors going bust all the time. In every sector you look, more than half of all companies have a negative return over ten years.

Let me repeat that: If you randomly pick stocks in any given sector, your most likely outcome is that you will have lost money after 10 years.

Of course, the big winners in the market make up for all those losses of the median stock and more which is why the average return of stocks in every sector is in the order 20% or so between 1926 and 2023 but the median return is negative because typically, some 55% of all stocks have negative returns over a ten-year period.

Median vs. average return in each sector

Source: Petajisto (2023)

This is why diversification is so important. Investors need to have at least 20 to 30 stocks in their portfolio to have a decent chance of being invested in the winners to make up for the losses of the duds. I am no fan of over-diversification and have argued that an active manager should not have too many stocks in the portfolio to have a decent chance of beating the market. But I am certainly no fan of under-diversification either, which is why I really don’t like the idea of single-stock ETFs. And this is why private investors are playing a dangerous game in their portfolios.

When I was in wealth management, we knew from experience that most clients had less than five stocks in their portfolios and household surveys confirm this. Indeed, most wealthy private investors have just one or two stocks in their portfolio and then adds a few ETFs or mutual funds to the mix to diversify. But that one stock often takes up 20%, 40% or more of their wealth.

This is understandable when the shares guarantee control over a business, or when for some legal reason the investor cannot sell the shares. But it makes no sense when the position is the result of having been granted these shares as a bonus and the investor is reluctant to take the hit from capital gains taxes. The cost of capital gains taxes may hurt today, but trust me, the cost of losing money from holding on to the stock is most likely going to be much higher in the long run. Remember: More than half of all stocks have lost money after ten years. What makes you so sure that your stock is not part of that group?