It is a core theory of investment that shares do better than bonds in the long term but you pay for this with greater volatility. Statistically, it has been shown that in any given year the chance of a painful fluctuation in the equity markets is higher than in the bond markets. It follows that a precondition of successful equity investment is having that combination of strong nerves and financial resilience, which allows one to ride out any short-term pain, so that the investment is maintained long enough to deliver a long-term payoff.
There is no end of research that shows that those who have a bad experience in stock markets are those who sell in the first two years of share ownership. Not for nothing do behavioural economists talk about ‘emotionally-adjusted returns’. The investor’s ability to manage stress when losing money is a significant ingredient in most successful strategies.
Professors Elroy Dimson, Mike Staunton and Paul Marsh, three academics long associated with the London Business School, have built their reputations in this area by compiling probably the world’s most comprehensive long-running study of stock market performance using data from over 70 of the world’s nations going back, in several cases, over 100 years. They publish the updated results every year – see Credit Suisse yearbook 2017
– and though the quantum varies depending on current events, the conclusion is invariably the same. The data shows that shares with all income reinvested deliver significantly higher long-term returns than bonds.
At first glance this is bad news for active fund management
Yet this comfortable theory is made a lot less comfortable when set alongside work done and published in 2017 by Hendrik Bessembinder, a Professor of Finance at Arizona State University. In a study that must have required mind-numbing resilience to complete, Bessembinder looked at the performance of every single US share on a month-by-month basis from 1926 to 2015 – some 26,000 stocks in all. What he found was that fewer than half made any money for the investor, and that the most common single result from share buying in his model is a total loss. His stark finding is that in 96% of cases investors would have been better off buying one-month US Government ‘T-bills’, which carry virtually no risk and have a minimal return.
Bessembinder’s research also shows that only 1,000 stocks, which are less than 4% of the total he researched, account for the entirety of the $31.8tn of wealth created by the US stock market in those 89 years. Within that total of 1,000, only 83 stocks account for more than half the gains. Exxon provides 3% of the total and Apple 2%. It is therefore hard to disagree with his observation that you have as much chance of getting in on the ground floor and finding the real winners’ stocks as you have of buying a winning lottery ticket.
However, it does quite negate the fact that the stock market does better than the bond market. Though his methodology has shown that nine shares out of ten turn out to be dogs in the end, the handful that do well are enough to drag up the performance of the market as a whole. The result is that over the kind of period he has been looking at, the return on stocks is two to three times the historic return on bonds.
Now at first glance this is bad news for active fund management. If you accept that finding a winning share is like trying to find a needle in a haystack then it makes sense not to bother, and to buy the whole haystack instead, in the knowledge, or at least the hope, that the needle is in there somewhere. That is what investors are doing when they buy passive index tracking funds.
Bessembinder’s conclusion shows how much more rewarding an active strategy could be
But a more detailed look at Bessembinder’s methodology delivers the opposite conclusion. He theoretically bought shares when they entered his market index and sold them when they exited that index, which, on average, was seven years later. He banked the performance between the entry and exit points.
But think about this for a moment. Business life is cyclical so assume a share enters the index at 100, rises to 200, but then falls back to 120, at which point it exits to be replaced by more dynamic stock. The gain Bessembinder would record across this lifecycle is 20%. However, the scope exists for an active manager to have bought at 100 and sold at the peak of 200, thereby recording a gain five times greater.
Bessembinder’s bleak conclusion is in fact a demonstration of the opportunity cost of passive management, showing how much more rewarding an active strategy could be. Currently the trend is entirely the other way – of money flowing from active to passive. But this is because too few active managers deliver on their promise, not that the concept itself is flawed. They just need to get better at it.
Anthony Hilton FCSI(Hon) is the award-winning former City editor of The Times and the London Evening Standard. He is also a columnist for The Review.
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