How hard is it to outperform the stock market and what are the risks of trying?
As a client of MASECO you would have heard us talking about the equity market return premium, which states that the equity markets have outperformed the risk-free rate of return (for USD benchmarked investors: one month treasury bills) over time by a significant margin. The graph below is a nice long term illustration of this:
At MASECO we also talk a lot about how important diversification between securities, markets and asset classes when trying to achieve higher risk adjusted returns.
Source: Dimensional Fund Advisors
Prof. Hendrik Bessembinder published one of my favourite papers in the Journal of Financial Economics called ‘Do stocks outperform treasury bills?’ which contained the following key findings (although I encourage reading the whole paper):
- 58% of common stocks underperformed 1-month US treasury bills over their lifetime (Centre For Research on Security Prices (CRSP))
- The entire outperformance of the U.S stock market is attributable to the best performing 4% of listed stocks, the other 96% collectively performed in line with US treasury bills
This illustrates just how difficult it is to outperform the general market through stock picking as one would have to find and stick with the few golden needles in the haystack. The fact that most stocks do not carry a positive risk premium (i.e. 58% underperform the risk-free rate) and that the single most frequent outcome over a stock’s full lifetime is a loss of 100% also tells us that stockpicking can be more akin to gambling than investing as the odds are stacked against the investor.
It is no wonder then that the vast majority of actively managed funds fail to beat their benchmarks and that those that outperform over one period, mostly fail to repeat their success over the next period. Dimensional Fund Managers undertake a large study each year where they look at exactly this and it is well worth a look: https://eu.dimensional.com/en/perspectives/dont-bother-trying-to-pick-stocks
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