At times of uncertainty, such as this, it can be tempting to run ‘what if’ scenarios in our heads, such as ‘perhaps I should move into tech stocks and pharmaceutical companies - as surely these sectors will do well’ or to pick out specific companies that appear likely to thrive in the future. Two challenges exist. The first is that you won’t be the first person to have thought this and these views in aggregate are already reflected in market prices. The second is that in making such concentrated bets you have a high chance of being wrong and missing out on the companies that actually end up driving future returns - Amazon didn’t exist 30 years ago.
To get a feel for what these concentration risks look like, academics are fortunate to be able to dig around in a vast bank of stock market data in the US, known as the CRSP database. One such study1 reveals some surprising and useful findings using data from 1926 to 2015. Whilst investment wisdom and empirical evidence support the notion that stocks – in aggregate - outperform cash over longer periods of time, a forensic look at individual stock returns tells a very different story. Here are some of the insights that the paper provides:
- The median time that a stock is listed on the CRSP database is only seven years, during the period 1926 to 2015. That’s not long.
- Just over 40% of all stocks have a holding period return that exceeds the return of cash (in this case one-month US Treasury bills) over the period that the stock was in the database. More than half deliver returns that are negative. The median lifetime return on any single stock was -3.7% p.a. That’s not good.
- 26,000 stocks have appeared in the CRSP database since 1926, yet only 36 stocks survived the entire 90-year period. That’s not many.
- US$32 trillion of wealth has been created since 1926 (to 2015), which has been generated entirely by the top 1,000 companies, representing less than 4% of the total number of companies listed over time. The top thirty firms (0.1% of all stocks) accounted for around 30% of the total stock market’s wealth creation. That’s pretty concentrated.
As the author states:
‘Non-diversified portfolios are subject to the risk that they will fail to include the relatively few stocks that, ex-post, generate large cumulative returns. Indeed the results help to understand why active strategies, which tend to be poorly diversified, most often lead to underperformance.’
At times like this – and in fact across all time periods – it makes enormous sense to remain highly diversified, as the risk of missing out on the next Exxon (the firm that has added most value to the US market ever), Apple or Amazon leads to missing out on the companies that actually end up driving future returns. Simply looking at the changing guard of the top ten US firms by revenues in 2000, 2010 and 2020 is revealing.
Figure 1: Top 10 US companies by revenue over time (2000, 2010, 2020)
Correctly picking which few companies are going to be driving stock market returns over the next decade or two will not be easy, or likely. Making sure that you own them can be achieved by owning a broadly diversified portfolio with many hundreds, if not thousands of companies in them. Missing out on these companies – perhaps that don’t even yet exist - could make all the difference between a good outcome and a very poor one. Remember, the old order changeth!
1 Bessembinder, H., (2017) Do Stocks Outperform Treasury Bills? WP Carey School of Business, Arizona State University.
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