We've detected that you're using an ad content blocking browser plug-in or feature. Ads provide a critical source of revenue to the continued operation of Silicon Investor.  We ask that you disable ad blocking while on Silicon Investor in the best interests of our community.  If you are not using an ad blocker but are still receiving this message, make sure your browser's tracking protection is set to the 'standard' level.
Pastimes : backstage

 Public ReplyPrvt ReplyMark as Last ReadFilePrevious 10Next 10PreviousNext  
From: skinowski7/22/2019 10:18:31 PM
   of 231
PWhy Many Global Investors Fail
PloutosJul. 22, 2019 9:48 AM ET
New academic research illustrates that the global equity risk premium has been attributable to only a small number of stocks.

While average returns are positive across markets, median returns for U.S. and global stocks trail the risk-free rate. Positively skewed strong performers tilt the market returns decidedly positive.

The article discusses implications of this research on portfolio construction.

The academic paper published in the past few years that most impacted my investment philosophy was Henrick Bessembinder's " Do Stocks Outperform Treasury Bills?" We know that the simple answer to the titular question is a resounding "yes." Over long-time intervals, the equity market has, on average, paid an investor a premium for taking equity risk.

In tracking nearly 26,000 stocks, Bessembinder found that a whopping 58% of stocks failed to outperform Treasury bills over their lifetimes in a long-term dataset, stretching back to 1926. On average, stocks outperform over long-time intervals, but the median stock in the U.S. equity market has actually produced negative alpha, an average return that trailed risk-free Treasury bills. This is a stat that should be of great interest to stock pickers out there.

Much of that paper focused on the fact that while the equity market generates above average returns on average, the fact that the median stock failed to generate a return above T-bills was a function of positive skewness in the cross-sectional distribution of stock returns.

That is a big thought, so let's break it down with an example. Imagine a stock that goes up by 30% or down by 30% with equal probability in a given period. The mean return is zero. In a two-period scenario, there are four potential outcomes:

In this example, the average return is zero, but the median return in negative. There is a three-in-four chance that you are going to generate a negative return, but the large return in the bull case offsets the negative cases. That is positive skewness, and the idea behind why the stock market has generated long-run excess returns, but most stocks have not produced a better return than bonds.

It makes intuitive sense. Over very long-time intervals, the maximum you are going to lose is 100%, but cumulative gains can be astronomical. The right tail of the distribution is much longer. Unfortunately, the most common cumulative return over a decade long holding period for stocks in the database is -100%. The positive excess returns for the market are a function of that long right tail.

Recently, Bessembinder combined with Arizona State colleague, Goeun Choi, and teamed with collaborators Te-Feng Chen and K.C. John Wei from Hong Kong Polytechnic University to extend this research to global markets. Their recent paper, " Do Global Stocks Outperform U.S. Treasury Bills?" covered 62,000 global common stocks trading on public markets in 42 countries from 1990 to 2018.

The fact that the equity market premia is driven by large gains in the tail of the distribution leads to some surprising facts in the global dataset:

While the average return was positive in all 42 countries examined, nearly 60% of global stocks (including 56% of U.S. stocks) did not exceed the accumulated return of rolling 1-month Treasury bills over matched time horizons.In total, stocks did extraordinarily well over this inclusive 29-year period, creating $44.7 trillion in wealth above the rolling Treasury portfolio even though the median stock failed to outperform this simple hurdle.Five of the 62,000 stocks in the study - Apple ( AAPL), Microsoft ( MSFT), Amazon ( AMZN), Alphabet ( GOOGL), and Exxon Mobil ( XOM) - represented just 0.008% of all stocks, but accounted for 8.27% of global net wealth creation.Just 306 companies (0.5% of total) accounted for 73% of net wealth creation. All of the net wealth was created by 811 global firms (1.33% of the total). Over this time horizon, less than 1% of non-US companies produced all of the wealth creation outside of the U.S. in this period.The top 5% of firms in each of the 42 countries created 42% of the wealth over this sample period.Of the 50 largest wealth creators over this time period, 34 were in the United States. The 16 outside of the U.S. were (in descending order by amount of wealth created (Tencent, Nestle, Samsung, Roche, Novartis, China Mobile, Taiwan Semiconductor, China Construction Bank, Unilever, Industrial & Commercial Bank of China, Toyota, Total, HSBC, Louis Vuitton Moet Henessey, L'Oreal). Conversely, 11 of the 20 largest weatch destroyers were Japanese. Only 4 were American - Worldcom, Viavi Solutions (formerly JDS Uniphase), Lucent Technologies, and Wachovia. To illustrate the impact of skewness on average returns, the table below shows 10,000 simulations produced by Bessembinder in his original U.S.-centric study where one stock is selected at random each month. The linked returns are then compared to zero, Treasury bills, the capitalization-weighted market portfolio, and the equal-weighted portfolio. The percentages indicate the proportion of simulations, which beat the targeted return.

As the time period extends, it is increasingly unlikely to beat T-bills let alone the equity market. Why? The random sampling is unlikely to capture the small number of stocks that generate a disproportionate share of the equity market's returns.

What are the implications for Seeking Alpha readers?

Diversification is extraordinarily important. Not only does it reduce idiosyncratic risk, but diversification also increases the likelihood that you own the small number of stocks that drive portfolio returns. Skewness was even more notable outside the U.S. with a smaller number of firms driving a large portion of total wealth creation.The positive skew of stock returns can be a siren's song for investors. Pick the right stock, and you can generate tremendous wealth. However, more likely than not you are going to pick a stock that generates middling or negative returns. It is no wonder it has been difficult to generate sustained outperformance through active management. That hurdle gets harder as time horizons extend.Over long-time intervals, the survival rate of companies is low, which may give further credence to the idea of Low Volatility strategies ( SPLV, USMV) that are more likely to avoid the all-too-frequent loss of principal. Stocks that bias up in Quality ( SPHQ), or have a long history of paying increasing dividends to shareholders ( NOBL) are more likely to compound and generate the positive skewness visible in multi-period returns. I encourage readers to peruse the excellent papers linked in this article, and discuss in the comments section.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long SPLV,USMV,SPHQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Report TOU ViolationShare This Post
 Public ReplyPrvt ReplyMark as Last ReadFilePrevious 10Next 10PreviousNext