As an equity fund manager, questioning the investment myth that equities outperform bonds is the equivalent of coprolalia, an occasional characteristic of Tourette's syndrome in which the sufferer involuntarily utters socially inappropriate remarks.
We all know that stocks outperform bonds over the long term, don't we? It is an integral part of the Capital Asset Pricing Model — or CAPM — in which rational investors demand an equity risk premium, and therefore return, for assuming the risk of investing in equities rather than bonds.
It has been popularised in works such as Jeremy Siegel's 1994 book Stocks for the Long Run. The main equity indices clearly outperform bonds.
However, a research paper by Hendrik Bessembinder published in the September edition of the Journal of Financial Economics posed the question "Do Stocks Outperform Treasury Bills?" with some rather worrying conclusions for most equity investors.
Prof. Bessembinder examined the performance of all the common stocks listed on the NYSE, Amex and Nasdaq (.IXIC) exchanges from 1926 to 2016 and found that only 47.8 per cent of the monthly returns from these stocks were greater than for one-month US Treasury bills in the same month.
When focusing on the stocks' return over their full lifetime as quoted entities, up until the end of the period or delisting — essentially a buy-and-hold strategy for all stocks — he found that only 42.6 per cent of stocks exceeded the return on one-month Treasury bills, even with dividends reinvested.
The reason that equity index returns beat US Treasuries while most of the stocks in them do not is really quite simple. Large positive returns from a few stocks offset the modest or negative returns from the vast majority of stocks.
In one sense this is not surprising. The study covers a 90-year period, but very few companies have long lives as quoted entities. In fact, during the period covered by the study, the median life was just 7.5 years. The rarer stocks which have been listed for longer have more time to compound in value and if they have been in existence as quoted companies for multiple decades the chances are it is because they are relatively successful businesses.
Nonetheless, the degree of concentration of returns is still startling. Just five companies out of the universe of 25,967 in the study account for 10 per cent of the total wealth creation over the 90 years, and just over 4 per cent of the companies account for all of the wealth created.
But does a 90-year study have much relevance to your actual investment experience? It is, after all, longer than the average life expectancy, let alone the average investing lifespan and covers a period which most investors probably regard as prehistoric. However, it would probably be wrong to dismiss the implications of the study for these reasons.
The study also looks at returns decade by decade and reaches more or less the same conclusion: that the decade returns for most equities are lower than those earned by investment in Treasury bills. Moreover, the results have been getting worse for equity investors more recently. Of the stocks floated between 1947 and 1956, 87 per cent had higher returns than US Treasuries. This fell to 61.5 per cent for those entering from 1957 to 1966 and just 31.7 per cent of those floated from 1977 to 1986.
Most alarmingly, the median stock entering the market since 1977 did not just underperform Treasuries but had a negative return. This may be attributable to the type of companies which floated in recent decades, which many have characterised as showing revenue growth, but very poor earnings.
What conclusions to draw from all this? Stocks in aggregate outperform bonds, but most stocks do not and positive returns are concentrated in very few stocks. Most active investors are doomed to underperform not only the equity indices but also bonds.
This outcome has largely been attributed to the impact of fees, other costs, lack of skill and institutional biases producing closet indexation. But it may also be because their portfolios are more concentrated than the index but not in the few stocks which can produce outperformance.
Last and by no means least, of course, it shows that the returns from active stock selection can be large if the investor selects a concentrated portfolio of the few stocks which offer positive returns. But if you are not confident you can identify the few stocks which outperform not just the indices but also bonds, then just buy the index.
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