Remember that the best hitter in baseball this year will fail 65 percent of the time.
— George Will
Mookie Betts hit .346 in 2018, failing 65.4% of the time. Mr. Betts reached base more often than his batting average indicates due to walks. His on base percentage (OBP), was .438, decreasing his failure rate to about 56%. Stocks, in the long run, have a similar failure rate.
Recent research from Hendrik Bessembinder of Arizona State¹ shows that from 1926 to 2016 just 42.6% of stocks provided lifetime returns that beat one month treasury bills. Fifty seven percent of stocks destroyed value over that ninety year span. If such a low percentage of stocks outstripped the return of a t-bill, how is it that stocks provided an 8.5% return over t-bills from 1926 to 2015? Back to baseball.
Batting average is indicative of skill, but it’s incomplete. It omits extra base hits. Slugging, the ability to hit doubles, triples and home runs, increases the value of a player immensely. In 2018, a high slugging percentage made the guy with the 56th highest batting average, a .270, the fifth most valuable batter. Conversely, just 5 of baseball’s sixteen .300 hitters made it into the twenty most valuable hitters when extra base hits are considered. In statistics, this outsize contribution per hit is called skewness.
Skewness is asymmetry, a tilting of outcomes one way or the other. Sluggers tilt the probability of scoring runs in the positive direction. Below are the outcomes from 2010-2015 when a lone runner was on each of the three bases with no outs. Pretty easy to see that someone who can hit doubles or triples, not to mention home runs, is valuable.
Stock returns make the skewness of baseball hitting look pedestrian. Five stocks of the almost 26,000 that existed at some point from 1926 to 2016 account for 10% of the wealth equities created relative to t-bills. It took 1092 stocks or just 4.3% to create all the wealth!
The amount of skewness it took to make that happen is like adding Bill Gates to a room of ten people with $100K incomes. The average income will become enormous, but the median won’t change at all. What makes this comparison really apt is that the median stock had a buy and hold lifetime return of -2.29% while the mean (average) lifetime return was over 18,000%. The latter translates into receiving $180 of value for every $1 invested.
If 42.6% of stocks had t-bill beating returns and 4.3% of them returned 100% of the value over t-bills, what happened with the other 38.3% that added value? That 38.3%, comprising almost 10,000 stocks, would have added about 17% more value. The value attributable to those 10,000 singles hitters managed to offset the negative returns and the positive sub t-bill returns of the 57% of equities that underperformed.
What does this mean for equity investing? Here are some possibilities:
- Diversification may matter even more than was believed. It’s very hard to pick winners, let alone the winners that are going to compound furiously. In order to increase the potential for including future return drivers in your portfolio, you must own a very diverse portfolio.
- Active managers may be perennially underperforming because they are under-diversified. Yes, you may win the lottery by investing with a particularly talented (or lucky) manager who holds a 50 stock portfolio, but don’t count on it. A corollary may be that active managers do have the skill to pick stocks that add value, but don’t have enough skill to pick the small set of big winners.
- Quantitatively selected portfolios may be at an advantage here, because they tend to hold a much larger number of stocks than those of traditional stock pickers. Quantitative processes have great breadth but not as much depth as fundamental processes. This leads to the spreading of bets across a wider range of stocks and more diversified portfolios.
- Skewness has been getting worse over the last few decades and this trend is likely to continue. Network effects have made it so very few businesses come to dominate their industry and to do so quickly in our current economy. Examples include Google in search, Amazon in shopping and Facebook/Instagram in social networking.
The important conclusion from this is that you may want to think of equity investing like a venture capitalist. Venture capitalists invest widely, expecting just a few investments to generate extreme returns to pay for all the firms that, however promising in concept, end up going nowhere.
¹ I have tried, to the best of my ability, to present Dr. Bessembinder’s research and some of his conclusions correctly. All mistakes in interpretation are my own, as are some of the conclusions.