There is a contradiction at the core of the stock market that makes investing at once simple and endlessly vexing:
Stocks have historically delivered the goods as an asset class, producing annualized gains of about 11% over nearly a century—but most stocks underperform.
Two pieces of research, studying the distribution of stock market returns over different markets and time frames, provide evidence for both phenomena.
Financial services firm SS&C Technologies (Nasdaq: SSNC)* looked at returns of U.S. stocks from 1926 to 2021 and found that (emphasis mine):
Since 1926, more than half of all stocks have had returns that are lower than what an investor would earn on a one-month treasury bill. … And it is not an artifact of trading in and out of stocks or some other facet of investor behavior—buy and hold returns for the majority of stocks are lower than what one would earn on a (very) short-term risk-free T-bill. It is not that T-bills themselves are secretly much more lucrative than most investors realize; instead, most stocks simply do not go up much over the long run.
How do we reconcile this reality with the fact that the stock market, on average, rises by about 10.8% annually? The answer is that a small subset of stocks power most of the market’s gains. In fact, the best-performing 4% of stocks account for the entire average return for the market as a whole. … [A]ll else being equal, there is a 24 out of 25 chance that any individual stock is not going to be such a stellar performer.
The second bit of evidence is in a forthcoming Financial Analysts Journal paper by Hendrik Bessembinder, Te-Feng Chen, Goeun Choi, and K.C. John Wei, “Long-Term Shareholder Returns: Evidence From 64,000 Global Stocks.” As the paper’s title suggests, the authors studied 64,000+ global common stocks spanning a 30-year period, from January 1990 to December 2020. The “small subset of stocks” from the SS&C research cited above becomes even smaller in this analysis (emphasis mine once again):
We document that the majority, 55.2% of U.S. stocks and 57.4% of non-U.S. stocks, underperform one-month U.S. Treasury bills in terms of compound returns over the full sample.
Focusing on aggregate shareholder outcomes, we find that the top-performing 2.4% of firms account for all of the $US 75.7 trillion in net global stock market wealth creation from 1990 to December 2020. Outside the US, 1.41% of firms account for the $US 30.7 trillion in net wealth creation.
To reiterate: The stock market has outperformed bonds and cash in most countries and over most time frames—certainly so in the United States. And yet… even buy-and-hold investors will be disappointed by the vast majority of stocks.
I think this core contradiction actually explains quite a bit about investing:
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It’s something that is simple to understand but impossible to predict
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It’s intuitive but vexing
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It’s simple on the surface but much more complex under the hood
It also shows the simple genius of Jack Bogle’s baby, the market-cap-weighted index, whereby the small percentage of superstar stocks will organically get a heavier weighting over time.
And, I think, it explains why short-selling and certain options strategies can work in a market that has tended to rise on average.
Here at 1623 Capital, even though we are an active management shop, I’ve long believed that indexing is great. But for me personally, the potential for smoothing out some of the choppiness of the market has appeal, as does the chance (never the guarantee) of concentrating in one (hopefully) or more (dreamfully) of those superstar stocks.
—Brian Richards, President & Chief Operating Officer, 1623 Capital
A short sale involves a theoretically unlimited risk of an increase in the market price of the security sold short, increasing the cost of buying those securities to cover the short position, and thus a possible unlimited loss.
* We use SS&C Technologies as our Fund Administrator.
