Joel Chang
- As we begin thinking of investing in equity, what do we have in mind? If one was to look to theory, it would be a CAPM, (Capital Asset Pricing Model) telling you that your Expected Return, [R = 𝑅f + 𝛽(𝑅m − 𝑅f)] would be proportionate to the beta, which is the stock’s sensitivity to the market as well as the risk premium. (Whereby; R = expected return, 𝑅f = risk free return, 𝛽 = beta, 𝑅m = market return). Another route of analysis would be a top down economic analysis, starting with the macro, stretching down to the industry and finally choosing the companies to invest in. With this in mind, how does this quote from a trust fund manager suit you?
“Everyone in stock markets who takes the CFA is brought up to believe there is something called an equity risk premium where you can take as much risk as you like and trade that for reward. That is not how the stock market works at all.” – James Anderson, Scottish Mortgage trust fund
Basically, we do know that equities outperform fixed-incomes, sometimes giving jack-pot returns. But to what extent does this tendency of outperformance benefit us in a real way? Before we start looking into the company’s balance sheet or their performance metrics to calculate something, we may as well learn the basic facts of equity returns. Especially, with this new article ‘Do stocks outperform treasury bills? (Hendrik Bessembinder, 2018)’ recently published in Journal of Financial Economics in October, 2018, we should rethink of what we know about stock market.
The main findings of the paper are:
The majority of common US stocks from 1926 to 2016 have lifetime buy-and-hold returns less than one month Treasuries.
Only 4% of the common stocks explains all of the wealth created by the equity market from 1926 to 2016
96% of the common stocks only delivered the return level equivalent to a one-month Treasury bill
If these facts found in the paper are not shocking enough, then you are already a really agile investor or probably an academic in finance. However, unless you are apathetic to the ongoing revelations in the investment universe, these findings are more than enough to make your eyes open to new thinking.
The paper then focuses on the skewness, (how asymmetric the possible return distribution is), of the stock returns and the concentration of wealth-creating stocks, in order to explain the somewhat bizarre findings.
If the return distribution of the stocks in the market have a shape like the ‘positive skew,’ the median return, (the return of the stock in the middle), is lower than the mean return. If the skewness gets bigger and bigger, it gets to a point where only the top few stocks are earning the money, and the rest are actually losing it, even though the mean return is positive.
While the skewness of a normal symmetric distribution is zero, any return distribution with a skewness over one (or less than minus one) would be considered highly skewed. The author shows that the skewness of the returns of stocks in annual terms is 19.8. The skewness of the returns of stocks in lifetime becomes 154.8.
With this backdrop of extreme skewness in reality, the author calculates ‘wealth creation’ by how much more wealth the stock created, exceeding the return of a risk-free fixed income. Top five firms, (Exxon, Apple, Microsoft, GE, IBM) created 10.07% of the total net wealth, and the top fifty firms created 39.29% of the wealth. Shockingly, top 4%, (or about 1,000 stocks) created 100% of the wealth created by the equity market overall.
What is amazing about this paper is that it does not jump to the results with one or two tests, but performs almost every possible simulations to see if the skewness and the concentrated wealth effects are truly certifiable. It shows how log-normality of stock returns itself can result in skewness of the expected returns in monthly term. It then develops to show how that skewness coming from the stocks themselves and the log-normality can be compounded to extreme in annual or decade horizon. It conducts simulation with different standard deviations of returns, and shows that the simulations are in accordance with the historical data.
Another astonishing thing about this paper is that it makes the traditional risk-aversion theory revolving around mean-variance and expected-utility seem somewhat lacking the essence of real risk. The risk that used to be associated with the high expected return coming from high volatility, should be now more associated with the skewness and the fear of not being able to include the top 4% stocks in portfolio.
Unless someone finds a loophole in this paper’s logic and counterstrikes the author, the findings of the paper seems to be undeniably stunning.
(You can check the details of the findings of the paper or download the paper through this link: https://wpcarey.asu.edu/department-finance/faculty-research/do-stocks-outperform-treasury-bills)
Now, how would you interpret these results of the paper with what you have known or how you have invested in stocks before?
If you want the good old ordinary equity-premium over fixed-income, diversification is the key. Only the fully diversified portfolio, (or the market portfolio having every stock in the market) will give the excess mean return above the fixed-income, since that is the way to include the top 4% by any chance.
On the other hand, you can start the endless effort to cherry-pick the top 4% that will give you the enormous excess returns, rather than diversifying your portfolio just to get that historical excess return. It is already happening in the investment arena.
“We ourselves are in the comparatively reassuring position that the search for almost unlimited asymmetric upside has been our main preoccupation – James Anderson, Scottish Mortgage Investment Trust, 2017”
However, if you want to be among the super-talented people picking up the 4% stocks, you should have a hard look at the top 50 stocks that have created 40% of the whole wealth creation. Do you see the common factors there? If there are one or two easy-to-find common factors there, it might be the longevity of the firm (Exxon, Texaco, ConocoPhillips, GE, Coca Cola, PepsiCo, DuPont, etc.) or the potential to growth (Apple, Microsoft, Alphabet, Amazon, Oracle, Cisco, etc.). But, what else do you find there?
The paper does not seem to give an explicit answer to your approach. It rather seems to give you a choice how to interpret the findings. Hence, it is giving you a challenge to think differently and get smarter when investing in equities.
