Most stocks suck. Here’s how to spot the ones that don’t

• Big drawdowns are just part of life in investing. Even a “perfect portfolio” equipped with godlike foresight would have seen a 76% drop in the past 100 years, along with five other plunges of 30% or more
• Most stocks – around 60% of them – have underperformed boring old short-term Treasuries. And most of the market’s actual wealth creation has come from a tiny number of stocks
• And since most active managers typically underperform the S&P 500, it’s really not surprising that passive investing has continued to grow in popularity.

With the uncertainty and overall volatility of the past few months, chances are you’ve been thinking quite a lot about drawdowns. And you’re hardly the only one. Investors have been busy rechecking their diversification and upping their safe-haven allocations, fearful about another gut-punching market drop. Even Morgan Stanley’s been poring over an almost 100-year study about stock returns to try to figure out what comes next.

Here’s what the investment bank has found.

Drawdowns, rebounds, and winning stocks

Morgan Stanley recently flagged a heavyweight study from Hendrik Bessembinder – a University of Arizona finance professor who crunched nearly a century’s worth of US stock data – 28,600 companies from 1926 to 2024 – to figure out which shares actually built wealth for investors. And he defined “wealth creation” as beating the returns of one-month Treasury bills – you know, the very assets that Berkshire Hathaway Inc Class B (NYSE:BRK.B) has shoveled $378 billion into, because it can’t find much else that meets its high investing bar.

Turns out, most stocks flopped. Bessembinder’s findings showed that almost 60% of those assets delivered returns that underperformed Treasury bills, essentially resulting in a $10.1 trillion loss of value through December 2024. The other 40% or so, meanwhile, created $89.5 trillion in value. And just 2% of the companies produced 90% of the total wealth creation of $79.4 trillion, with the top six (Apple Inc (NASDAQ:AAPL), Microsoft Corp (NASDAQ:MSFT), NVIDIA Corp (NASDAQ:NVDA), Alphabet Inc Class A (NASDAQ:GOOGL), Amazon.com Inc (NASDAQ:AMZN), and Exxon Mobil Corp (NYSE:XOM)) alone kicking in $17.1 trillion.

He also zoomed in on 6,500 stocks from 1985 to 2024 to track their worst plunges. The median stock lost 85% from peak to trough, and took two and a half years to hit bottom and then another two and a half years to claw its way back to its previous highs. That is, if they managed a comeback: over half never returned to their peak. The average return was 340% of the original highs, but that’s only because the market’s highest-flyers skewed the stats upward. Remember the math of compounding – a 90% drop needs a tenfold return just to break even.

Even the winners took a beating: Amazon dropped 95% during the dot-com crash. Nvidia fell by 90% in 2002 and took over four years to get back to its peak. Both eventually roared back to life – Nvidia’s stock gained an average 39% a year over two decades – but the journey was anything but smooth. Even the S&P 500 sank 58% at one point.

And that’s actually par for the course. As Charlie Munger – Warren Buffett’s legendary right-hand man – has famously said, you have to expect a 50% investment drop two or three times a century.

And with just a small clique of stocks driving most of the market’s gains, it’s no wonder even the pros struggle to stand out. Only 35% of active fund managers beat the S&P 500 in 2024. And that’s far from an anomaly – it’s right in line with the norm, according to S&P Global.

Makes sense, then, that S&P index trackers have taken off – they perform better and often charge a lot less than managed funds helmed by professional stock pickers.

That being the case, University of Chicago finance professor Wes Gray did a further thought experiment with the S&P 500 data. He wanted to know what would happen if you could build the perfect stock portfolio with godlike foresight, picking the companies that would deliver the highest total shareholder return, rebalancing every five years, and weighting it all by market cap, from 1927 to 2016. Even that “perfect-foresight portfolio” saw a whopping 76% drawdown (from August 1929 to May 1932), along with five other stomach-dropping plunges of 30% or more.

So, yes: even a flawless portfolio can rattle your nerves. And that’s why it’s important not to wager the money you might need in the short term in stocks – the market might not be kind when you need to cash out.

And how to take advantage of the rebounds

Even though passively investing in broad-based, index-tracking ETFs makes a lot of sense, there’s still value in knowing what separates the stock winners from the flatliners.

For starters, top performers tend to fall less, recover faster, and outperform over time. So if you’re watching stocks or screening them, look for the ones that hold up better than the rest during a selloff. They’re often the ones that bounce most when sentiment improves.

And then weigh up the company, asking these questions, put together by Morgan Stanley Investment Management, after its deep dive into Bessembinder’s research.

Is the company’s decline “cyclical” or “secular”? Cyclical pain – for example, a slowdown caused by a recession – can and usually does pass. But a secular wound is terminal. That’s why hedge fund founder Bill Ackman recently grabbed up shares of Amazon: its stock dip was about big economic worries, not life-or-death fears about the tech giant itself.

How does the company make money? If the company creates value, there’s hope for a rebound. Check out its customer lifetime value, for instance: the metric subtracts customer acquisition costs from the present-day value of the cash flows a customer generates over time for the firm.

How committed is this company to big, expensive projects? Flexible companies that have fewer massive sunken costs can be a lot more nimble when they need to be.

How strong are its finances? Distressed stocks generally underperform safer stocks. So check out a company’s financial strength before wading in, especially after a big drawdown. Healthy balance sheets bounce, but weak ones break.

Can the company raise funds if it needs to? A lack of liquidity can lead to big troubles, even if a company is solvent.

How honest is the leadership team? When there are issues, denial only delays turnarounds. But transparency tends to speed them up.

So when your portfolio takes a hit, don’t flinch – remember this is all part of the drill. Instead, ask the tough questions and run the test. If it passes, it might be worth sticking around for the rebound.

Russell Burns is an analyst at finimize.

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