Skewed trees

Don’t get skewed (on returns)

One of the best ways to become fabulously wealthy is to make a concentrated bet on a single stock. It is also one of the best ways to underperform and, in some cases, lose everything (see Enron).

The combination of survivorship, hindsight bias, and skewed returns makes this somewhat hard to grasp (unless we really think about it). We observe the winners and forget (or never hear about) the losers. Hindsight bias makes it seem – once we know the outcome – as if the winners were obvious from the beginning. That is, we knew all along that Apple and Microsoft would be worth ~$2 trillion. Then add in highly skewed returns i.e., a few companies generate outsized returns over the long run – and overconfidence.

Picking winners is easy. When you know who won. It is much harder when everyone is on the starting line, which is when it matters. If it seems obvious after the fact, that is hindsight bias at work. For example, how many purchased Amazon 20 years ago and still hold it today? Why not if it was obvious?

Hendrik Bessembinder has a thoughtful paper that has had a huge influence on me. He looks at U.S. stock market returns 1926-2016 and asks “Do Stocks Outperform Treasury bills?”

1) Most individual stocks return less than one-month US Treasury bills (over their life). But the stock market AS A WHOLE outperforms US Treasury bills over the long run. How is this possible? While a majority of stocks falls short, some stocks have HUGE returns.

2) 42% of stocks created positive wealth (in excess of one-month Treasury bills for the matched time period). Said differently, over half of stocks (58%) destroyed wealth.

3) 0.4% of stocks (~90 out of ~25,000) accounted for over half of net wealth creation* 1926-2016. 4% (~1,100) of stocks accounted for 100% of the net wealth creation. The remaining 96% collectively accounted for zero net wealth creation (some are positive, some are negative contributors).

4) 31% of stocks generate lifetime returns that exceeded the market portfolio (for the matched time period). Importantly, though, this ignores friction costs (management fees, trading costs, taxes).

5) Five companies – Exxon, Apple, Microsoft, GE, IBM – accounted for ~10% of wealth creation by themselves over this 90-year period. (As of 2019, the top five includes Amazon and Alphabet.)

6) GM, despite filing for bankruptcy in 2009, was one of the top 10 wealth creators. It paid out billions of dollars in dividends before going to zero. Sears also made the top 50.

In the understatement of an academic, Bessembinder concludes:

The results…imply that the returns to active stock selection can be very large, if the investor is either fortunate or skilled enough to select a concentrated portfolio containing stocks that go on to earn extreme positive returns. Of course, the key question of whether an investor can reliably identify in advance such “home run” stocks, or can identify a manager with the skill to do so, remains.

Some people will read this and believe they are the ones capable of identifying the winners in advance (and staying with them through their ups and downs). If they choose wisely, they’ll become rich.

Exceptional stock picking skill and the stomach to hold on for the long run is rare. The other option is to be incredibly lucky, which is impossible to predict in advance. The only way to guarantee you’ll own the winners is to own the entire market.

*in excess of one-month T-bill rates.

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