Investing with conviction isn't necessarily a good idea. That may seem a bit counterintuitive, particularly with respect to manager selection. After all, an active manager's best ideas can shine more in a compact, high-conviction portfolio than they could in a better-diversified portfolio. It's hard to surmount active fees without taking bold active bets. But as portfolio concentration increases, so do the odds of underperforming the market.
Do Stocks Beat Treasuries?
Hendrick Bessembinder, a professor at Arizona State University, illustrates this effect in his provocative paper, "Do Stocks Outperform Treasury Bills?"[1] In it, he demonstrates that most U.S. stocks not only underperformed the market from 1926 through 2016, they also underperformed Treasuries. Over the nine decades he studied, 69% of stocks lagged the broad equity market and 57% failed to outperform Treasuries. This abysmal showing seems inconsistent with the level of compensation that investors demand for equity risk. So, how does this result square with the strong long-term performance of the stock market as a whole?
A small minority of stocks were responsible for most of the market's returns. Bessembinder found that the best-performing 4% of all U.S. stocks generated all the market's gains. The remaining 96% were collectively flat: The wealth generated by the next 38% was wiped out by the bottom 58%, which lost money. In statistics-speak, the market exhibited positive skewness: The big winners pulled the mean (average) return above the median (middle) return, which was negative.
To illustrate, consider the data in Exhibit 1, which shows the dispersion of returns of the stocks in the index over the trailing five years through July 2018. The right-hand tail is longer than the left-hand tail, which pulled the average return of the stocks in the index slightly above the median and created a modest positive skew.
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It isn't surprising to find this type of pattern, and it's not just applicable to stocks. Whenever there is a limited lower bound and no upper bound, it is common to find that a few observations have a disproportionate impact on the average, whether it's the distribution of wealth or productivity. As securities with limited liability, stocks' downside is capped at negative 100%, but their upside is unlimited. This means that the gains from the big winners more than compensate for the losses among the big losers. Big winners can turn into dominant competitors (for example, Facebook (FB), Microsoft (MSFT), Alphabet (GOOG), Amazon.com (AMZN)), earning strong returns while they establish and widen their economic moats, which can further contribute to positive skewness.
Compounding tends to increase this positive skewness over time. This is because the winners in successive periods grow at higher rates than the losers, pulling the mean stock return further above the median over time. High volatility also increases skewness. When volatility is high--as it is for most stocks--the odds that a stock will underperform the market increase with the holding period. This is because the effects of skewness overpower the benefits of stocks' positive mean return. Bessembinder found that 46% of stocks beat the market over a one-month horizon. That figure fell to 37% at the 10-year horizon. The odds of success were lower for small-cap stocks than they were for large caps, as their higher volatility led to greater skewness.
In part 2 of this article, we will look at how diversification comes into the discussion.
[1] Bessembinder, H. 2017. "Do Stocks Outperform Treasury Bills?" Department of Finance, Arizona State University.
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