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Stock Returns Aren’t What You May Think

 

The brutal truth is that most stocks are a poor investment. That’s a shocking claim because it runs counter to widely held assumption that most stocks will be a good investment if held long enough. After all, investors are constantly reminded to stick with their investments for the long-term and are told that patience and discipline eventually will be rewarded. Right?

Not necessarily, and that’s because returns are inseparable from risk. Good returns are not guaranteed over any time horizon. Returns may turn out other than as expected. Risk is an inherent feature of stock investing, but what exactly do we mean by risk?

If you ask most investment advisers, the explanation will quickly veer into a discussion of standard deviation. Standard deviation is a widely used measure of the volatility of returns or how widely returns vary over time. Stock prices are subject to potentially large swings and an investor needs to consider the possibility that the market may be down when the investor needs to draw funds from the portfolio.

Under this conventional understanding, risk is quantifiable. If you pick investments with a standard deviation value that falls within your range of acceptable risk, then you have properly managed your risk exposure. But standard deviation is not the only or even the best measure of risk.

The ultimate risk of stock investing is the potential for the permanent loss of capital. And the risk that a particular stock will lose most or all of its value turns out to be much greater than many would expect.

A recent paper called “The Capitalism Distribution” by the investment firm Longboard highlights just how bad the returns can be for many individual stocks. This study covered a 24-year span from 1983 to 2006. Its key findings were that most stocks are a poor investment, a significant number are downright lousy investments, and only a small number of stocks account for virtually all the market gains in the U.S. market.

Most stocks, nearly 65%, underperformed the broad US market as measured by the Russell 3000 Index. Even worse, nearly 40% of stocks lost money over the entire period and nearly 20% lost at least 75% of their value. Framed differently, the odds of picking a winning stock were about 1 out of 3; the odds of losing money were roughly a 2 out of 5; and the odds of losing a lot of money were nearly 1 out of 5.

Another interesting finding was the distribution of returns. Virtually all the gains came from the top 25% performing stocks, and about one-quarter of those stocks made a disproportionate contribution to the total market return. Just over 6% of stocks outperformed the market by more than 500%.

That equates to nearly 500 companies who hit it out of the park, so to speak. The trick, of course, is to find those companies in advance, rather than to simply read about them in after the fact. On the other hand, a sizeable minority of stocks lost money and about 4% of stocks (just over 300 companies) underperformed the Russell 3000 by at least 500%.

These numbers validate what we already should know about the challenge of active stock selection: identifying the winners and avoiding the losers are simply two sides of the same coin.

Another recent study, “Do Stocks Outperform Treasury Bills?” looked at individual stock performance over a much longer period, from 1926 through 2015, and reached similarly discouraging conclusions about the risk of stocks.

This study found that most stocks over their lifetime couldn’t beat the return to holding one-month Treasury Bills over the same time horizon. Barely 50% of stocks even produced a positive rate of return over their lifetime. Approximately 1,000 of the top performing stocks, less than 4% of all the stocks that existed over the 90-year period, accounted for virtually all of the wealth created by the stock market.

The two studies confirm that most individual stocks are a poor investment and that a small number of stocks contribute disproportionately to the total market return. As the second study concluded, “very large positive returns to a few stocks offset the modest or negative returns to more typical stocks.” If true, what are the implications for investors?

One is that investors need a pragmatic understanding of risk that distinguishes between temporary loss and permanent loss. The risk of owning stocks is not simply that they can go down in value at inopportune times. That is a temporary inconvenience that only becomes a realized loss if the investor sells into a down market. The real risk of stock investing is the potential for permanent loss of capital by investing in stocks that permanently lose value.

A second implication is that investors need to ask themselves a very important question when forming their investment philosophy. Is it more important to own the “winners” or to avoid the “losers?”

Active stock selection is based on the premise that astute stock managers can weed out the losers and identify the winning stocks. The outsized returns from a small handful of top performing stocks make this approach very tempting. The best-performing stocks produce results not unlike winning the lottery. Unfortunately, the annual SPIVA reports by Standard and Poor’s demonstrate that very few managers are successful in this quest and there always lurks the possibility of extremely negative outcomes.

The other approach says, just make sure you own the winners. If you own the market, you own the winners. You own the losers too but the net return from the market has been more than acceptable. And now you understand why it is so important to diversify.

 

This article appeared in the November 16th, 2017 issue of The Daily Record. Download a PDF copy.