Last 100 Years for the Active Equity Investing
Historically, equities outperformed bonds (6.5% vs. 2.0% p.a. in real terms). That’s not surprising at all, but it is less understood that equities actually underperformed bonds over the last 18 years. According to Credit Suisse’s Global Investment Returns Yearbook 2018, equities generated only 3.5% real returns per year vs. bonds’ 5.0%.
Annualized Real Returns on Asset Classes
In fact, against conventional wisdom, not many stocks actually outperformed bonds. According to Prof. Bessembinder’s recent study, Do Stocks Outperform Treasury Bills?, only 42.6% of common stocks have lifetime buy-and-hold returns that exceed the buy-and-hold on one-month Treasury Bills over the same time periods. He analysed the data compiled by the Centre for Research in Securities Prices (CRSP) on approximately 25,300 companies from 1926 to 2016. Another interesting fact from this research is the concentration of profits generated by the limited number of stocks. For the 90 years, the most profitable 30 companies (0.12% of the population) created 31% of the total market wealth. This list of the most profitable 30 companies looks similar to the constituents of the Dow Jones Industrial Average (DJIA), and it is interesting to see which companies are not on the list. Among the 30 companies, 21 were the current or former members of the DJIA. Altria and General Motors are two interesting cases. Both companies created wealth significantly larger than the current market cap ($112bn and $49bn) as they returned capital to investors through dividends and divestments (e.g. Altria’s spinoff of Kraft Foods).
As the chart below shows, a randomly-picked concentrated portfolio will not beat value-weighted market returns. According to the study, a randomly-picked Single Stock Portfolio will most likely underperform both 1-month T-bill returns and value-weighted market returns. A stock portfolio’s probability of outperformance will increase as the portfolio becomes more diversified, but even portfolios of 100 randomly-picked stocks will have a difficult time outperforming the broader market.
Bessembinder’s research indicates that a concentrated and long-term investment approach does not necessarily generate great returns. To beat 1-month T-bill returns, which seem to be a low hurdle, you only need to invest in a random portfolio of 5–10 stocks. However, to beat the market return, your portfolio must be concentrated on the future winners — in other words, it must be drastically different from the current “market” portfolio. Most actively-managed mutual funds, which track the market return benchmarks by design, and many hedge funds, who care about their short-term relative performance, are destined to underperform. Independent thinking is what we are missing in this asset management industry today.
