Most stocks – four out of every seven – offer risk but little return. In the majority of cases, you’d probably be better off sticking your money in the post office.
That's the somewhat shocking conclusion of Do Stocks Outperform Treasury Bills?, a new study which examines the performance of almost 26,000 US stocks over the last 90 years.
Treasury bills, or T-bills, are short-term US government bonds that invariably offer low returns (currently, they yield about 0.5 per cent). For risk-averse investors, the attraction of T-bills is that they offer guaranteed returns.
In contrast, stocks are risky, but investors hope to be compensated for the risk they take by ultimately earning higher returns.
Most of the time, however, individual stocks fail to deliver. Professor Hendrik Bessembinder from the University of Arizona finds that since 1926, less than half of stocks actually generated any returns for investors. Just 42.1 per cent earned more than risk-free treasury bills over the entire period.
Although stocks have a reputation as an excellent long-term investment, many don’t actually last very long – the median time that a stock is listed on an exchange is just over seven years, according to Bessembinder.
Not everyone wants to buy and hold stocks for the long run, of course, and market-timers may feel they can earn better returns over short periods. The data doesn’t support this confidence, however; less than half of stocks earned positive returns over one-month periods.
Puzzle
The notion that most stocks offer high risk but little return may seem ridiculous. After all, the US stock market has delivered average annual returns of more than 9 per cent over the last century.
Returns have been lower outside the United States but stocks have nevertheless beaten bonds and bills in every developed market over that time. The scale of this outperformance is so large that the differential is widely referred to as the "equity premium puzzle". How can equity markets be a good place to invest if most stocks turn out to be turkeys?
The answer is simple – stock markets have delivered big long-term returns because of the stupendous returns earned by a tiny minority of companies. Bessembinder calculated that the US market has earned $32 trillion (€30 trillion) for investors since 1926. Of the 25,782 stocks in his sample, some $16 trillion (€15.1 trillion) in wealth creation was generated by just 86 companies. The top 1,000 stocks accounted for all of the $32 trillion wealth creation.
Put another way, one third of one per cent of stocks accounted for half of the overall market gains; less than 4 per cent accounted for all of the market gains; the remaining 96 per cent collectively generated lifetime dollar gains that merely equalled the amount earned through treasury bills.
Oil giant Exxon Mobil has generated more wealth for investors – $939.8 billion (€881.4 billion) – than any other company in history. Apple, with $677.4 billion (€635.3 billion), is next; although Apple's current market capitalisation is greater than Exxon's, the former has been a public company for more than twice as long, and the dividends generated over that timeframe means it occupies the top ranking.
The top five list in terms of lifetime wealth creation is completed by General Electric, Microsoft and IBM.
Implications
For stock-pickers, these findings carry important implications. Firstly, while it’s clearly silly to invest your money in a single stock, those who insist on doing so have a better chance of earning decent returns if they choose a large-capitalisation stock above a small-cap stock.
This may seem surprising, given that researchers have long known that small-cap indices have historically delivered bigger returns. Again, however, this is due to the lottery-like returns generated by a small minority of small-caps.
Most small-caps are losing bets – less than half earn positive returns over 10-year holding periods, compared to 80 per cent of large-stocks. Just over one-third of small-caps beat T-bills over decade-long holding periods, compared to 69.6 per cent of large-caps.
Secondly, stock-pickers need to realise the buy-and-hold mantra applies to diversified indices but not to individual stocks. Most stocks, even if held for long periods, will not keep up with inflation. If you put all your eggs in one basket, you have a tiny chance of huge returns but a much greater chance of mediocre returns.
Thirdly, the importance of wide diversification cannot be underestimated. It’s common for investors to assume that if they buy 10 or 20 random stocks, they have a 50-50 chance of beating the market. This is not the case.
A very small minority of “super-stocks” account for the bulk of index returns. If your portfolio is limited to a relatively small number of stocks, it’s highly unlikely to contain the handful of big winners that drive long-term index returns.
Bessembinder notes that it’s commonly assumed that most active portfolios underperform benchmarks because of transaction costs and behavioural biases. While these factors are very relevant, he argues that many active funds tend to be poorly diversified, and this alone means that sub-par returns are likely.
Bessembinder's study is currently a draft, but any future changes are unlikely to alter the key message, given that other researchers have come to similar conclusions. For example, Longboard Asset Management research shows that between 1983 and 2007, two in five stocks turned out to be money-losing investments. Almost one in five lost at least 75 per cent of their value.
Again, overall index returns during that period were driven by the huge gains generated by a very small minority of stocks.
Timing
It's long been known that market timing is a perilous game, with the bulk of market returns occurring on a small number of days. For example, research shows that since 1994, more than 80 per cent of the equity premium on US stocks has been earned over the 24 hours preceding Federal Reserve policy announcements. Those announcements occur only eight times a year, but they can make all the difference.
The same is true of stock-picking – if you miss the few big winners, you miss out on market returns. Daredevil investors who plough their money into one stock are taking lots of risk for little return. Stock markets invariably beat inflation; alas, the same is not true of individual stocks.
