How’s your portfolio holding up in volatile 2020? For many investors, it depends on what they have in there. This was confirmed by a study published by Professor Hendrick Bessembinder (Arizona State University) in the prestigious Journal of Financial Economics.i The study analyzed the returns on 25,000 stocks traded on U.S. markets between 1926 and 2016. The results may surprise you.
It’s normal for stocks to earn far greater returns than treasury bills (T-Bills), a phenomenon known as the equity premium. The U.S. stock market has been one of the best performing in the world since 1926, with its total return exceeding that of T-Bills by a margin of 0.65% on average per month and 8.55% annually. Therefore, we would expect most stocks to outperform T-Bills. The problem is that they don’t. According to Bessembinder’s study, only 48% of stocks outperform T-Bills each month, while 46% beat the market’s total return. In the long term (several decades), only 43% of stocks do better than T-Bills, and only 31% beat the market. So, what’s behind this contradiction?
According to the study, the equity premium can generally be explained by a small portion of stocks providing exceptional returns, while the majority of individual stocks actually under-perform. This is called return asymmetry, and it is even more pronounced in the long term, because volatility erases some of the wealth created, reducing the number of high-performing stocks. Here’s an example: say you buy a stock for $100 for your portfolio. The first year, your return is 25%, so you have $125. But the next year, your stock has a return of -25%, leaving you with $93.75 in capital. After two years, your average return is 0%, but you still wind up in the red!
Since there are so many underperforming stocks, return asymmetry means that over 10 years, a portfolio containing only one stock, chosen at random, has only a 30% chance of beating the market. As more stocks are added to that portfolio, the probability quickly goes up. But even a portfolio of 100 stocks has only a 47.5% chance of outperforming the market, and that’s before management fees. And this is not unique to Wall Street—a follow-up studyii by Bessembinder and three other researchers found similar results on the global market.
Even before management fees, a small, concentrated portfolio has little chance of outperforming the market. Stocks may tend to outperform T-Bills on average, but the fact is that this is disproportionately driven by the wild success of a small minority of stocks.
If you or your manager have access to some truly exclusive information—and I mean something not even Goldman Sachs or Caisse De Dépôt know about—congratulations! You can accurately and regularly predict which investments will outperform. If not, an index portfolio made up of bonds and global stocks with low management fees is your best bet for getting a good return for the risk involved.
Ask your financial advisor about it!
