Guest view: Study prompts question: Do you feel lucky?
Averages can be deceiving. In stock investing, this can be extremely costly.
When hearing about how well the S&P 500 index is doing — it has hit dozens of new highs in 2017 — do you ever wonder how many stocks in this index are performing well? And how well?
The S&P 500 figures represent the average performance of the stocks of 500 large companies. And as with all averages, a few extremes can significantly affect the results. A few high-performing stocks these days are driving the S&P 500’s record performances.
As it turns out, that’s been the case with the overall U.S. stock market for the past 90 years. Any stock investment is inherently far more risky than investing in U.S. Treasuries, widely regarded as the safest investment you can make. But over the last 90 years, the U.S. stock market’s entire gains, above those of Treasury bills, has come from just less than 4 percent of stocks.
Collectively, the other 96 percent only matched the returns of one-month Treasuries, and 58 percent returned even less. Unless you were extremely lucky and happened to own stocks in this 4 percent, you were needlessly taking on additional risk for which you wouldn’t have been compensated. Had you just owned Treasuries instead, you would have received the same returns with far less risk.
This is among the astonishing conclusions of a landmark study by Hendrik Bessembinder, a finance professor at Arizona State University. Before this study, there was already abundant evidence that market averages have long been held up by a few high-performing stocks. His comprehensive study of the performance of U.S. stocks from 1926 through 2015 is getting a lot of attention globally because of what it reveals about the degree and pervasiveness of the statistical phenomenon known as skewing.
Skewing means a few numbers in a group significantly affect the average of the group. Let’s say that five kids in a class of 25 get a score of 100 entire on a test, and the other 20 get a score of 68 — a failing grade. Though most kids failed the test, the average score is 74 — a passing grade. Without looking at the breakdown of scores, you’d probably think that the class had a better grasp of the material than they actually did. This is because the kids who scored 100 skewed the results.
In the stock market, skewing can mean that a few extremely high performers can create a rosy impression — the wrong impression — for those who don’t take a closer look. Only by examining stock performance carefully over decades, as this seminal study does, can you get an accurate picture of how most stocks have actually fared.
The study found that half of the wealth created by the market’s nearly 26,000 stocks — $32 trillion above that created by Treasury bills — came from only 86 stocks. Further, it found that the lifespan of the average stock was just seven years, and only 36 existed for the entire 90-year period. Thus, for nearly a century, just a few stocks have driven the domestic market’s long-term averages, carrying the others.
The study’s findings underscore the futility of trying to pick winning stocks. The odds against success are overwhelming because it’s impossible to know which stocks will do well, and when.
Because investors don’t know that market averages are skewed, they don’t see that their chances of succeeding in stock picking are extremely low. Too many individual investors take a doleful page from the book of professional stock pickers, whose results are well below the average returns of the market.
Instead of speculating by picking stocks — or, even worse, paying someone else to do it for you — it’s far better to capture the returns of the market through a globally diversified portfolio of low-cost index funds. That way, you’ll be certain to own the precious few who carry the rest.
Going down the other road brings to mind Clint Eastwood’s character in the movie “Dirty Harry,” who famously asked: “Do you feel lucky?”
Tim Decker is president of ISI Financial Group, a wealth management firm in Lancaster, and a fee-only financial planner. His weekly call-in radio show, “Financial Freedom,” airs Saturdays at 10 a.m. on WHP 580 AM.
This content is based upon information believed to be accurate by ISI Financial Group Inc. However, it is not intended to provide specific financial advice. Investing involves risk, including the loss of principal. Past performance is no guarantee of future performance. You should always seek professional guidance before making any financial or legal decisions, as everyone’s needs are different.