Was this the greatest trade ever?


The Sunday Times 08 July 2018

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In one of comedy’s great scenes from the movie Dumb and Dumber, Lloyd Christmas, one of the main characters, whose love for the female lead is unrequited, is trying to establish what the chances are of the two of them ending up together. Mary, the female lead, diplomatically replies “Not good”.  Lloyd’s reply is “Not good, like one in 100?”. Mary clarifies “I’d say more like one in a million.” An elated Lloyd responds: "So you're telling me there's a chance. Yeah”!!

Unwarranted optimism, it seems, is as much a compulsion for Lloyd Christmas as it is active fund managers. The stock-pickers statistical odds for success may not be quite as dire as Lloyd’s, but a report from Hendrik Bessembinder of Arizona State University paints a pretty bleak picture.

The author analysed nearly 26,000 US stocks from 1926 until 2016 and calculated the lifetime shareholder wealth creation of the stock market during this period to be nearly $35 trillion. The top 90 stocks (less than half of one percent of the total number) were responsible for a full 50% of the total wealth created. The entire $35 trillion gain was attributable to a hardly credible 4% of the stocks. Almost equally incredible is Bessembinder’s finding that 58% of stocks have under-performed US short term bonds over their full lifetime.

The fact that stock markets have provided long term returns that exceed the returns to low risk investments, such as Government bonds, has been an accepted and long standing market phenomenon. It is easily rationalised on the basis of return for risk taken - a necessary condition of capitalism. If I am going to risk my money investing in the equity of a business and accept the attendant risks, then a healthy capitalist system will be one that rewards me with a return that is higher than that available on low (or no) risk alternatives, like cash deposits.

However, the fact that most of the stocks in the analysis provided returns that fell short of those earned on so-called riskless bonds, and worse still, that over half deliver negative lifetime returns, will come as a surprise to many.

And these effects do not seem to be disappearing. Another study by Heaton, Polson, and Witte shows a similar effect for the period 1989-2015. Individual stock winners such as Amazon for example, which has returned a tidy 35,000% return since 1999 versus 181% for the S&P500 index, shows the extent of the winner takes most effect.

The observation that you need to pick winners to beat the benchmark is not news. That’s what fund managers are paid for after all. However,  the complexities of market dynamics make the odds against picking winners prohibitively long.

Heaton, Polson, and Witte distil stock picking difficulties into a simple illustration, adapted here by Rob Arnott of Research Affiliates using a bag of poker chips as an example. “Say you have five poker chips, four worth $10 and one worth $100. The five chips have an average value of $28, but what if you reach into the bag and pull out two chips over and over? That’s roughly how mutual fund managers approach stock picking, selecting portfolios that are subsets of the broader group. The problem is, the majority of selections will fail to snag the $100 chip. Mathematically, there is an average value of $56 across the 10 two-chip combinations—the problem is 6 of 10 times you’ll grab a pair with a sum of $20. The same thing happens with stocks chosen from a benchmark. Only a few managers will own the biggies, relegating the rest of the industry to mediocrity—or worse.”

That there is such a concentration of extraordinary returns in a minority of companies within a stock market index is tantamount to a career death sentence for anyone who gets paid for beating a benchmark. Active manager underperformance is often attributed to transaction costs and fees. These results show that underperformance can be anticipated more often than not for managers with poorly diversified portfolios, even in the absence of costs.

We could interpret these results as implying that the returns to stock picking can be very large, if the investor can select a concentrated portfolio containing stocks that go on to earn extreme positive returns. Based on the evidence of a twenty year career in investment markets, I choose not to draw this conclusion.

The investing industry is filled with brilliant people and abysmal results. Winning requires a level of intellectual flexibility and nimbleness that is beyond all but the most savvy of investors.

For the would-be amateur investor, determined to try and pick the winners, there’s a chance of success, but not a great deal better than that offered to Lloyd Christmas. The good news is that diversified access to stock market returns are widely available and easy to access through ETFs or index funds. Save your million to one long shots for the lottery.

Gary Connolly is Managing Director of iCubed. He can be contacted at gary@icubed.ie or on twitter @gconno1. iCubed Training, Research and Consulting, trading as iCubed, is regulated by the Central Bank of Ireland.

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