By LARRY SWEDROE
Individual stock ownership offers both the hope of great returns (finding the next Google, for instance) and the potential for disastrous results (ending up with the next Enron). Because investors are not compensated for taking the risk that their result will be the disastrous one — the market doesn’t compensate investors with higher expected returns for taking risks that are easily diversified away—the rational strategy is to not buy individual stocks. Unfortunately, the evidence is that the average investor, while being risk averse, doesn’t act that way. In a triumph of hope over wisdom and experience, they fail to diversify.
Given the obvious benefits of diversification, the question is: Why don’t investors hold highly diversified portfolios? One reason is that it’s likely most investors don’t understand just how risky individual stocks are. So that you don’t have that excuse, we will review the global evidence, beginning with the evidence on U.S. stocks.
Hendrik Bessembinder contributes to our understanding of the risky nature of individual stocks with his study Do Stocks Outperform Treasury Bills?, published in the September 2018 issue of the Journal of Financial Economics. His study covered the period 1926 through 2015 and included all common stocks listed on the NYSE, Amex and Nasdaq exchanges. Following is a summary of his findings, which will likely shock most readers:
- Only 47.7 percent of returns were larger than the one-month Treasury rate.
- Even at the decade horizon, a minority of stocks outperformed Treasury bills.
- From the beginning of the sample or first appearance in the data through the end of sample or delisting, and including delisting returns when appropriate, just 42.1 percent of common stocks had a holding period return greater than one-month Treasury bills.
- While more than 71 percent of individual stocks had a positive arithmetic average return over their full life, only a minority (49.2 percent) of common stocks had a positive lifetime holding period return, and the median lifetime return was -3.7 percent. This was because of volatility and the difference in arithmetic (annual average) returns versus geometric (compound or annualized) returns. For example, if a stock loses 50 percent in the first year and then gains 60 percent in the second, it has a positive arithmetic return but has actually lost money (20 percent) and has a negative geometric return.
- Despite the existence of a small-cap premium (an annual average of 2.8 percent), smaller capitalisation stocks were more likely to have returns that fell below the benchmarks of zero or the Treasury bill rate. Just 37.4 percent of small stocks had holding period returns that exceeded those of the one-month Treasury bill. In contrast, 80 percent of stocks in the largest decile had positive decade holding period returns and 69.6 percent outperformed the one-month Treasury bill.
- Reflective of the positive skewness in returns, only 599 stocks, just 2.3 percent of the total, had lifetime holding period returns that exceeded the cross-sectional mean lifetime return.
- The median time that a stock was listed on the Center for Research in Security Prices (CRSP) database was just more than seven years.
- Only 36 stocks were present in the database for the full 90 years.
- A single-stock strategy underperformed the value-weighted market in 96 percent of bootstrap simulations (a test that relies on random sampling with replacement) and underperformed the equal-weighed market in 99 percent of the simulations.
- The single-stock strategy outperformed the one-month Treasury bill in only 28 percent of the simulations.
- Only 3.8 percent of single-stock strategies produced a holding period return greater than the value-weighted market, and only 1.2 percent beat the equal-weighted market over the full 90-year horizon.
We now turn to the international evidence.
Jiali Fang, Ben Marshall, Nhut Nguyen and Nuttawat Visaltanachoti contribute to the literature with their study “Do Stocks Outperform Treasury Bills in International Markets?,” published in the May 2021 issue of Finance Research Letters. Their data sample covered more than 70,000 stocks in 57 countries over the period 1996 through 2017. Following is a summary of their findings:
- More than half the common stocks in the majority (55 of 57) of international equity markets generated total returns less than local Treasury bill returns.
- The average cross-country proportion of stocks outperforming was 42.4 percent compared to 49.7 percent in the U.S.—individual stock underperformance is even more prevalent internationally.
- There is a sizeable variation in the extent of this underperformance, ranging from as low as 30.8 percent in Columbia to 55.1 percent in Bangladesh. Switzerland, the other country with a majority of stocks outperforming, at 51.0 percent, was the only developed country with a slight majority of individual stocks outperforming local Treasury bills. In 18 countries, less than 40 percent of individual stocks outperformed their local Treasury bills.
- A greater proportion of stocks underperform in countries with weaker governance, less individualistic investors, less openness to trade and foreign equity market investment, less financial market development and weaker economies (lower growth, higher inflation and higher unemployment).
- The results were robust to sub-period tests.
Most common stocks do not outperform Treasury bills over their lifetimes. The research findings highlight the high degree of positive skewness (lottery-like distributions), and the riskiness, found in individual stock returns. For example, Bessembinder noted that the 86 top-performing stocks, less than one-third of 1 percent of the total, collectively accounted for more than half of the wealth creation. And the 1,000 top-performing stocks, less than 4 percent of the total, accounted for all of the wealth creation. The other 96 percent of stocks just matched the return of riskless one-month Treasury bills! The implication is striking: While there has been a large equity risk premium available to investors, a large majority of stocks have negative risk premiums. This finding demonstrates just how great the uncompensated risk is that investors who buy individual stocks (or a small number of them) accept—risks that can be diversified away without reducing expected returns.
Such results help explain why active strategies, which tend to be poorly diversified, most often lead to underperformance. At the same time, the results potentially justify a focus on less-diversified portfolios by investors who particularly value the possibility of lottery-like outcomes despite the knowledge that the poorly diversified portfolio will most likely underperform. For example, Bessembinder showed the impact of the preference for lottery tickets with this finding: Only 31.5 percent of monthly returns to stocks in the lowest share price decile exceeded one-month Treasury bill rates compared to 59.1 percent of monthly returns to stocks in the highest share price decile.
The results from the studies we have examined serve to highlight the important role of portfolio diversification. It has been said to be the only free lunch in investing. Unfortunately, most investors fail to use the full buffet available to them!
Bessembinder added this observation: “The results here focus attention on the fact that poorly diversified portfolios may underperform because they omit the relatively few stocks that generate large positive returns. The results also help to explain why active portfolio strategies, which tend to be poorly diversified, most often underperform their benchmarks. Underperformance is typically attributed to transaction costs, fees, and/or behavioral biases that amount to a sort of negative skill. The results here show that underperformance can be anticipated more often than not for active managers with poorly diversified portfolios, even in the absence of costs, fees, or perverse skill.”
The takeaway for investors is that it is vital to ensure that the minority of stocks that add value beyond Treasury bills are not excluded from their portfolios. With that said, it has also been well established (e.g., the study Lottery Preference and Anomalies) that “lottery” stocks — those offering the potential for outsized returns, like penny and growth stocks—have delivered poor performance. But there are investors who have a “taste,” or preference, for lottery-like investments—investments that exhibit positive skewness and excess kurtosis. And it leads them to irrationally (from a traditional finance perspective) invest in high-volatility stocks (which have lottery-like distributions), driving their prices higher, resulting in poor returns. In other words, they pay a premium to gamble. Thus, investors can improve performance by screening such securities out of their portfolio.
Fund families whose investment strategies are based on academic research, such as Alpha Architect, AQR, Bridgeway and Dimensional Fund Advisors, have long excluded stocks with lottery characteristics from their eligible universe.
(Full disclosure: My firm, Buckingham Wealth Partners, recommends AQR, Bridgeway and Dimensional funds in constructing client portfolios.)
The information presented herein is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Certain information may be based on third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Performance is historical and does not guarantee future results. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth® or Buckingham Strategic Partners® (collectively Buckingham Wealth Partners). LSR-21-94
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