Is this a dumb question? Doesn't everybody know that stocks beat every other asset class, especially the lowly T- Bill? The answer may surprise or even shock you.
Most stocks do not outperform T-bills. And a recent study proves it.
Stock-pickers look for names that can deliver alpha, the excess return over the market return. But a recent study examining historical stock returns since 1928 debunks the nearly universal belief that most stocks outperform T-bills over the long-term.
How can this possibly be true? There are two keys to this puzzle - survivorship bias (delisted stocks are removed from index return records) and skewness (the lopsided distribution of stock returns).
The paper, written by Arizona State University professor Hendrik Bessembinder, "Do stocks outperform Treasury bills?" looked at 25,300 companies that issued stock from 1926 to 2016.
He used the Center for Research in Security Prices (CRSP) database for the study. What he discovered is that only 42.6% of these stocks outperformed T-Bills. (The stock returns used in the study include dividends.)
Furthermore, he found that only 4% of the companies analyzed, or 1,092 firms, accounted for all of the net wealth that has been created over the full 90 year period of his study. The remaining 96% of companies collectively generated lifetime dollar gains matching those of one-month Treasury bills.
If you're thinking that this guy is just another perma-bear who doesn't have any standing in the research community, note this: his study was published in September, 2018 in the prestigious Journal of Financial Economics.
Skewness - the lopsided distribution of equity returns
Of the 25,300 stocks in the CRSP dataset, just five stocks — Exxon Mobil, Apple Inc., Microsoft, General Electric, and IBM — accounted for 10% of total wealth creation.
According to the study, "while the overall U.S. stock market has handily outperformed Treasury bills in the long run, most individual common stocks have not."
Put differently, the outperformance of the stock market is mostly due to the relatively few companies that became "ten-bagger" stocks.
Survivorship Bias - sweeping the losers under the rug
When an index sponsor like S&P or Dow Jones calculate the long-term returns of their index, they ignore stocks that were delisted, whether it was due to dissolution, merger, or simply a failure to meet the standards of the index committee.
This causes survivorship bias, because the companies that are removed are treated as if they were never part of the index at all. The CRSP dataset includes these fallen angels.
That's why I have more confidence in the CRSP numbers than the official Index numbers.
When it comes to picking winning stocks, is it luck or skill?
There is no doubt that the rewards for skilled stock selection can be very large, if the investor is either lucky or skilled enough. Of course, the key question of whether an investor can reliably identify in advance which stocks will become "ten-baggers," and which will end up in the dust bin of the CRSP dataset.
There are a few very skilled stock pickers out there, but most of them have already started their own hedge fund and you can't get in unless you have about $10 million to invest. And you have to pay exorbitant fees for the privilege of membership.
Then there are the lucky ones who have managed to string together a series of winning yeare without much skill and a ton of luck. By the time they get on your radar their run of luck is probably close at hand.
Factoids - snippets of information I picked up from the study
- Rates of underperformance are highest for small caps.
- 96% of all stocks collectively match the return of 1 month T bills over their lifetimes.
- Just five firms (Exxon Mobile, Apple, Microsoft, General Electric, and IBM) account for 10% of the total wealth creation.
- The 90 top performing companies, slightly more than one-third of 1% of the companies that have listed common stock, collectively account for over half of the wealth creation.
- The 1,092 top performing companies, slightly more than 4% of the total, account for all of the net wealth creation.
It's been getting worse lately
The number of stocks that return less than Treasury bills is greater for those that entered the CRSP database in recent decades, thanks in part to a surge in new listings after about 1980 that included increased numbers of risky stocks with high asset growth but low profitability, and low ex post survival rates.
A few more notable factoids from the study
- While the median lifetime buy-and-hold return is negative, the cross-sectional mean lifetime return is over 18,000%.
- The maximum lifetime buy-and-hold return is 244.3 million %, by the firm now known as Altria Group.
- The fact that the broad stock market does outperform Treasuries over longer time periods is attributable to the positive skewness of the stock return distribution, i.e. to the relatively few stocks that generate large returns, not to the performance of typical stocks.
- The observation that most stocks underperform Treasury bills in the full CRSP dataset is attributable to stocks that entered the database since 1966. For stocks that entered the database
- in earlier decades, a majority, ranging from 61.5% of stocks entering between 1957 and 1966 to 87.0% of stocks entering between 1947 and 1956, had lifetime buy-and-hold returns larger than one-month Treasuries over the same horizons.
In contrast, for stocks entering the database since 1966, a minority outperform Treasury bills over their lifetimes, ranging from 31.7% of the stocks that appeared between 1977 and 1986 to 46.9% of stocks that entered the database between 1967 and 1976. In fact, the median lifetime return is negative for stocks entering the database in every decade since 1977.
Fama and French (2004) show an increase in new listings characterized by negative earnings and strong asset growth, while Fink et al. (2010) show that the firms brought to market in recent decades have tended to be younger.
The largest amount of wealth creation attributable to any firm is $1.002 trillion, by Exxon Mobil. The second largest wealth creation is attributable to Apple, which created $745.7 billion in shareholder wealth, despite a CRSP life of only 433 months (compared to 1,086 months for Exxon Mobil and other firms that were present for the full sample.)
Microsoft ($629.8 billion), General Electric ($608.1 billion), International Business Machines ($520.2 billion), Altria Group ($470.2 billion), Johnson and Johnson ($426.2 billion), GM ($425.3 billion), Chevron ($390.4 billion), and Walmart ($368.2 billion) comprise the rest of the top ten firms in terms of lifetime wealth creation.
The results presented here reaffirm the importance of portfolio diversification, Poorly diversified portfolios will underperform because they omit the relatively few stocks that generate large positive returns.
The results in this paper imply that the returns to active stock selection can be very large, if the investor is either fortunate or skilled enough to select a concentrated portfolio containing stocks that go on to earn extreme positive returns.
Of course, the key question of whether an investor can reliably identify in advance such "ten-bagger” stocks or can identify a manager with the skill to do so, remains.
My takeaways
For a retail investor, picking stocks that will beat the market is very hard. It can be done, but what are the odds of success? According to the paper, they're less than 50-50, and that's just for beating T Bills. If a retail stock-picker wants to beat the market, the bar is significantly higher.
This leads to the ultimate gut-check question: what is your edge as a stock-picker? You must have one if you're going to compete against pros who have better technology, more financial resources, industry contacts, and an army of researchers from the top schools in the world. Your chances of beating these pros are slim, but not zero.
Ask yourself: can I win a game that has the odds stacked against me, while playing against seasoned pros who have me out-gunned? Think about it.
I have not checked in here for some time as I thought it was getting boring, but the last several posts are good quality so I guess I’ll add you back to my everyday bloglist. You deserve it my friend 🙂