Here’s a simple truth every stock investor needs to know:
A small minority of stocks have an outsized influence on the market. The other stocks? They barely matter.
When calculating the S&P 500 index, the top 42 stocks in the index have the same weighting as the bottom 461. (And yes, there are 503 stocks in the S&P 500. …Don’t ask.) The top 10 stocks have the same influence as the bottom 382. Apple has as much weight as the bottom 181 companies.
This is called “market cap weighting.” The biggest companies (those with largest market cap) make up a larger fraction of the index. Makes sense, right?
Market cap weighting results in a “Pareto” distribution, or “fat head, long tail.” A small number of stocks have a large influence on the index, and vice versa.
During bull markets, this fact makes it statistically hard to beat the market.
To beat the market, your first task is identify stocks that beat the market average. Duh. But this a tall task. According to Meb Faber’s research, about 35% of stocks beat the market average over the long run (it’s another Pareto distribution, albeit less severe in nature).
But your second task is to make sure those winners actually have a large weighting in your portfolio. If you build a market-cap weighted portfolio (a logical thing to do), you’ve got limited options. We already established that only 42 of 503 S&P stocks (or 8.3%) are larger than the average stock in the index. Most stocks are small. Even if you pick a great winning stock, it won’t matter if it’s too small a fraction of your portfolio.
During bear markets, this idea is reversed. It’s statistically easy to beat the market.
Because just as bull markets are driven by a small number of big winners, bear markets are driven by a small number of big losers.
Let’s look at 2022 and divide the S&P 500 into 20 even groups (or “ventiles”). Each ventile contains 25 stocks (and a few contain 26…stupid S&P 503).
- The top 16 ventiles this year, or best ~402 stocks in the S&P 500, have a combined performance of 0%. No gain, no loss.
- But the bottom 4 ventiles, or worst 101 stocks, account for all of the negative performance this year. The entire -20.54% (as of this writing).
- The bottom ventile, or worst 25 stocks, accounts for 67% of the index’s total negative performance. Those 25 stocks are performing so poorly, they drag down the entire 500+ stock index by ~13%. Yikes!
Beating the market in this scenario becomes statistically easy, because only 5% of stocks account for 67% of the negative performance! Even a dart-throwing monkey could avoid those big losers. Just don’t hit the 5%, monkey!
In fact, that’s exactly what happens if we put monkeys to the test. I used Google Sheets and the “GoogleFinance” function to randomly create 25 portfolios of 30 stocks each and compare their 2022 performance to that of the market index. A few stats:
- In total, the 25 portfolios had an average performance of -19.38% (vs. the S&P 500 performance of -20.54%)
- 15 of the portfolios beat the market, with an average year-to-date performance of -13.39%
- 10 of the portfolios lost to the market, with an average year-to-date performance of -28.38%
But more interesting was why certain portfolios won or lost. Specifically, the losers all contained a “big loser” – a bottom 25 stock with a significant 2022 loss. Tesla, Meta, Google, Nvidia, Adobe, etc.
The “winners” all avoided the big losers.
So…Time to Pick Stocks?!
So – am I advocating you try to beat the market? Let me answer that question with another question:
Which is more common – bull markets or bear markets?
The answer is bull. Seriously. It’s bull markets. And we already established that the market is statistically hard to beat in bull markets. Most of the time, we’re in a bull market – when the market is hard to beat!
“But we’re in a bear market right now Jesse…so…???”
We are in a bear market right now. True. But to take advantage of the “strategy” above, you would’ve needed to start this strategy at the beginning of the year, before we entered the bear market. You’d be crazy (or lucky, or divinely skilled) to engage a bear market strategy during a bull market.
“Ok, I can’t go back in time…but why not try right now!?”
The same market timing question applies. How sure are you this bear market will last another 6 months? Another year? Are you sure you’ll time the market and transition back to a bull market strategy before it’s too late?
You need to big winners on your side in bull markets. You can’t risk missing them because, at one time, you were worried about them being a big loser. It’s just not worth it.
Use this enticing bear market lesson to inform your full-time investing mindset:
Don’t look for the needle in the haystack. Just buy the whole haystack.Jack Bogle
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