Worse than cash

Chris Dillow

Chris Dillow
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Worse than cash
Everybody knows that shares beat cash in the long run. In one important sense, however, this is just not true. In fact, most shares underperform cash.

Hendrick Bessembinder at Arizona State University has studied the performance of all the 25,782 shares that were listed on the US stock market at some time between 1926 and 2015. He's found that only 42.1 per cent of these have had a return over their lifetime that exceeded cash. "Most stocks do not outperform Treasury bills over their lives," he concludes. Most shares either fail or do badly until they are taken over.

In fact, estimates Professor Bessembinder, only half of US shares stay on the market for seven years or more.

Our belief that shares do well owes something to survivorship bias: the shares we look at are the ones that have survived - so far. But these are unrepresentative of all shares.

But if most shares underperform cash, how come the overall market has done so well down the years?

Simple. It’s because returns are positively skewed: the most you can lose on a share is 100 per cent, but your maximum possible gain is enormous. A few stocks do make such gains, and they account for most of the rise in the market. Professor Bessembinder estimates that between 1926 and 2015 US shares created $31.8 trillion of wealth for shareholders in dividends and capital gains. However, just two stocks - Apple and Exxon - accounted for more than 5 per cent of this; 86 stocks account for half of it; and 983 account for all of it. In other words, all of the wealth that has been created by the US stock market since 1926 is due to less than 4 per cent of all the shares that have existed since then. <--- dafuq you chance is less than 4% to become winner


The US might not be exceptional in this regard. The fact that the Aim index has fallen since its inception in the mid-1990s tells us that hundreds of shares destroy wealth. Alex Coad at Sussex University has shown that younger, smaller companies in particular face "high exit hazards". And in the longer run even big companies fail. Of the 100 largest employers in the UK in 1907, for example, only three are independent listed companies today.

For years, the folk wisdom in venture capital has been that most investments will fail, a few will break even and that, with luck, stellar gains on a few great successes will more than offset losses on most projects. The same seems to be true of quoted stocks.


In fact, there are powerful reasons why equity returns are skewed, with high ones so rare.

One is that companies face diseconomies of scale. As organisations get larger they become harder to manage. CEOs lose contact with the truth of what's really happening on the shop floor and extra layers of management add to costs and bureaucracy and create opportunities for rent-seeking and even theft: Luigi Zingales at the University of Chicago has estimated that around one company in seven is the victim of significant fraud, so BT might not be as unusual as you think.

There's another reason why most firms do badly: doing so is a sign of a healthy market economy. In a competitive market, profits should be rare and temporary; they should be competed away. Remember that in the textbook theory of perfect competition, profits are minimal.

And in at least one important respect, this is true in the real world. William Nordhaus at Yale University has shown that shareholders capture only a "minuscule fraction" of the overall benefits of innovation, because profits are driven down by competition. What's good for consumers, though, is not good for shareholders.

This is why Warren Buffett advises stock-pickers to look for companies with "economic moats" - things such as brand power or an entrenched market position that allows them to fight off potential rivals. Such moats, though, are rare and where they exist are impermanent: Kodak, to take just one example, had a moat for years - until digital photography came along. <-- property has the best moat in the universe and it is permanently moated.

All this amounts to a strong case for tracker funds, especially if you are a long-term investor. It helps explain why so many actively-managed funds underperform the market. It's because, says Professor Besseembinder, "poorly diversified portfolios may omit the relatively few stocks that generate large positive returns". If only a handful of companies generate big returns, then being underweight in a few stocks carries a huge penalty - and given that corporate growth is largelyunpredictable, there's a big danger that you will be underweight.

In a race with a big field, it’s better to back the field rather than a particular horse.