Easy Money

Jonathan Clements
Director of Financial
Education
cpi@creativeplanning.com

Wall Street may not be paved with gold, but sometimes it sure feels that way. Amazon was recently trading at almost $1,200, versus a split-adjusted $1.50 when it went public in 1997. Apple’s stock is at $170, compared with $12.19 at year-end 2008. Bitcoin soared toward $18,000 in December, up from less than $1,000 a year ago. Getting rich—and outperforming the market averages—has rarely seemed easier.

But appearances can be deceiving.

We hear a lot about Bitcoin, Apple’s shares and Amazon’s stock, just as we hear a lot about lottery ticket winners, airplane crashes, bad behavior by politicians and movie stars, and skyrocketing Honus Wagner1 baseball cards. Meanwhile, we don’t hear nearly so much about lackluster investments, losing lottery tickets, well-behaved politicians and movie stars, worthless baseball cards, or how flying is far safer than driving.

This skewed flow of information influences how we view the world—and, when it comes to investing, makes beating the market seem far easier than it really is.

But make no mistake: The odds of outpacing the averages are slim indeed. Consider a new study by Hendrik Bessembinder, a finance professor at Arizona State University. He looked at U.S. stock performance over the 90 years through December 2016.

His startling discovery: The market’s entire 90-year gain, over and above Treasury bills, could be attributed to just 1,092 companies, equal to 4% of all stocks. The other 96% collectively matched T-bills.

Indeed, half the wealth created over this 90-year stretch can be explained by just 90 stocks, including ExxonMobil, Apple, Microsoft, GE and IBM. That’s a mere 0.36% of the stocks that traded during this period. Most of the other 25,000 listed companies weren’t nearly so impressive: Stocks typically stuck around for just 7½ years—and a majority lost money during their usually brief life.

In other words, if you had picked just one or two stocks, the odds suggest you would have got your head handed to you. Surprised? At issue is a phenomenon known as skewness. In any given year, the most a stock can lose is 100% of its value, but its potential gain is 200%, 300% or more.

Each year, the market’s big winners skew the market averages higher. Those big winners make headlines, leaving the nation’s professional and amateur stock jockeys salivating at the gains they missed—and hankering after the next hot stock. But that hankering usually proves to be their undoing.

To understand why, consider a simple example. Suppose the stock market had just 10 stocks, all of which started the year with the same total stock market value. Over the next 12 months, nine of the 10 stocks climb 10%, while the tenth rose 110%.

If you picked just one stock, you had a 90% chance of ending up with one of the nine stocks that climbed 10%. To be sure, a 10% gain is nothing to sniff at. Problem is, the market average would have jumped 20%, as it was driven higher by the one stock that soared 110%. Result: Most stocks—and hence most pickers of stocks—would have badly trailed the market average.

No doubt these stock pickers would despair at their bad luck, blame the lousy advice they got from their broker or their brother-in-law, and vow to do better next year. From now on, they tell themselves, they’ll spend even more time reading company annual reports, move even faster to dump lagging stocks and listen even more intently to Jim Cramer. In future, they won’t buy just any old shares. Instead, they’ll only buy the best stocks.

This, of course, is what money managers who run stock mutual funds endeavor to do. It hasn’t worked out so well for them or their shareholders. For proof, check out the regularly updated study of actively managed funds put out by S&P Dow Jones Indices, a unit of S&P Global.

S&P’s most recent analysis found that, over the past 15 years, just 7% of large-cap U.S. stock funds outpaced the S&P 500-stock index, 6% of mid-cap funds beat the S&P MidCap 400 and 6% of small-cap funds outshone the S&P SmallCap 600. The 15-year results for bond funds and international stock funds were almost as grim.

Feeling discouraged? Don’t despair. There is one strategy that will guarantee you own the next year’s top-performing stocks. It’s remarkably simply: All you have to do is own all stocks.

Did I hear a groan?

It turns out that the strategy we use to reduce risk—broad diversification—is also the strategy that improves our odds of impressive long-run investment performance. If we use index funds to capture the results of the market at the lowest possible cost, we’ll never have the thrill of outperforming the averages and we can’t be sure we will make money in any given year. But we are guaranteed to outperform most competing investors, whose results will be dragged down by their far higher investment costs.

In short, if we don’t try to pick the winners, we will win. Easy money? It doesn’t get much easier.

 

1Have you noticed how Peter Mallouk always uses footnotes in his client letters? What’s that all about?