What is the average return of the U.S. stock market? The answer that has been accepted as an undeniable truth among investors is that the average annual return is around 10%. The annualized return of the most followed U.S. large cap equity index between January 1st, 1920 and January 1st, 2025, is 10.50% (dividends reinvested). If you take the simple average of annual returns during the last 100 years, the answer you will get is 12.49%. This means that the common wisdom of 10% is truth, right?

But let’s look at things the other way around. If you would have invested your money in a single large-cap public company with a good balance sheet in the year 1920 and never sold your stocks, what kind of return would you have received by 2020? If we assume that you would have received an annual return of 10% for a $1,000 investment, your investment would now be worth $13,780,612 (compound interest has a huge effect). But in real life, the value of your investment in the year 2020 is pretty much guaranteed to be closer to zero than to $13 million. Why is that?

The reason for this is that there are a very few public companies that have survived more than 100 years. Most of them have gone out of business at one time or another. Of course, many companies are not around anymore because they have been bought by their competitors and owning stocks of these acquired companies would have often provided you with a very nice return. But then you would have needed to find another company to put your money in and you might not have been as lucky with that investment.

In a fascinating study by Prof. Bessembinder (“Do Stocks Outperform Treasury Bills?”) from Arizona State University, Prof. Bessembinder examined the actual lifetime returns of all public U.S. companies (25,332 companies) between 1926 and 2016. The study examined what would have happened if you would have held stocks from all companies already public in 1926, then always invested in every new company that was listed and then never voluntarily (in case of mergers & acquisitions you were forced to sell) sold any of your stocks.

One of the key results of this thought-provoking study is that the single most frequent outcome (when returns are rounded to the nearest 5%) for individual common stocks over their full lifetimes is a loss of 100%.

If you would have never sold any of your stocks, more than half of your stocks would have delivered negative return and just 42.6% of your stocks would have provided better returns than one-month Treasury bills between 1926 and 2016. Then what can explain the annual average return of 10%? Are the calculations all wrong?

The explanation for the long-term outperformance of stocks compared bonds is that a very small number of companies have provided extraordinary good returns for investors. According to Prof. Bessembinder, 4% of the public companies have provided all the returns of the whole U.S. stock market while the other 96% of the common stocks have either provided negative results or just kept their original values. As a even more shocking fact, just 0.36% of all the companies have generated more than 50% of all stock market returns between 1926 and 2016.

It’s important to remember that the components of a stock index are not fixed but they keep changing. So if you invest in a fund or an ETF that follows a certain stock index, you are not putting your money into the same exact companies over a long period but every year a certain number of index companies are replace with new stocks when the market values of some companies decrease too much or if there are mergers among the index companies. So investing in an index means that you are always automatically getting rid of the worst performing companies and investing in rising companies whose stock price has increased in the near past.

When you are investing in stock indices instead of single companies, you are much more likely to have at least a small portion of your money invested in the tiny portion of the stocks that are generating most of the long-term stock market returns.

Is passive investing the only viable option for investors?

Many researchers remind that the results of the paper are not really that novel but the paper has still been able to spark a lot of discussion around the topic. If the amount of winners is so small does active stock picking make any sense? Is passive indexing the only serious option that every investor should consider?

The results of Prof. Bessembinder’s paper have been confirmed and accepted by both academics and practitioner but many people claim that the passive indexing is not necessary the only takeaway from the study. For example Jack Vogel from Alpha Architect says that while the paper is a very strong argument that investors should definitely buy diversified portfolios, it doesn’t say which individual stock characteristics should be placed in these diversified portfolios. It has been demonstrated that portfolios focusing on factors like value and momentum have outperform benchmark indices in the long-term. So while investing in a handful of individual companies might not make much sense in a long run, building factor based portfolios might increase your changes of having the best performing stocks as part of your portfolio while minimizing the number of worst performing companies that you own.