Do Stocks Outperform Bonds?

Individual stock returns versus Treasury bills provide a different view of their out and underperformance

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Nov 19, 2018
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We have seen that if you have a long-term time horizon, stocks are probably the right way to go. But are they?

We know that stocks as an asset class outperform bonds over long periods. In fact, for the last 200 years there has not been any 20-year period where stocks have lost money. We also know that the higher volatility of stocks is reduced considerably the higher the holding period.

However, Terry Smith of the Fundsmith Equity Fund in a recently published article mentioned a research study by Professor Hendrik Bessembinder for the Journal of Finance in which he asked “Do stocks outperform bonds?” He had some worrying conclusions.

The study

The abstract of Bessembinder’s study is the following:

“The majority of common stocks that have appeared in the Center for Research in Security Prices (CRSP) database* since 1926 have lifetime buy-and-hold returns less than one-month Treasuries. When stated in terms of lifetime dollar wealth creation, the best-performing 4% of listed companies explain the net gain for the entire US stock market since 1926, as other stocks collectively matched Treasury bills. These results highlight the important role of positive skewness in the distribution of individual stock returns, attributable to skewness in monthly returns and to the effects of compounding. The results help to explain why poorly diversified active strategies most often underperform market averages.”

* Contains all common stocks listed on the NYSE, Amex and Nasdaq exchanges.

The focus of this paper is on the returns of individual common stocks. In that sense, the author shows that “most individual US common stocks provide buy-and-hold returns that fall short of those earned on one-month US Treasury bills over the same horizons, implying that the positive mean excess returns observed for broad equity portfolios are attributable to relatively few stocks.”

In fact, from 1926 to 2016, only 47.8% of stocks produced larger returns than the one-month Treasury rate in the same month. When focusing on stocks’ full lifetimes (from the beginning of the sample in 1926, or first appearance in CRSP, through the 2016 end of the sample, or delisting from CRSP), just 42.6% of common stocks, slightly less than three out of seven, had a buy-and-hold return (inclusive of reinvested dividends) that exceeded the return of holding one-month Treasury bills over the matched horizon.

More than half of CRSP common stocks delivered negative lifetime returns. The median time that a stock was listed on the CRSP database between 1926 and 2016 was seven and a half years.

We also know that small caps in aggregate produce better compound returns than large caps. Well, again, on an individual basis, the conclusion is the contrary: The median return is worse.

Concentration of returns

So, how can the returns of the overall stock market be much better than the returns of bonds while the majority of individual stocks fail even to match Treasury bills? The answer, Bessembinder said, can be attributed to the fact that the distribution of individual stock returns is positively skewed. Simply put, large positive returns on a few stocks offset the modest or negative returns on more typical stocks. The positive skewness in long horizon returns is attributable both to skewness in the distribution of monthly individual stock returns and to the fact that the compounding of random returns induces skewness:

In fact, of the “25.300 companies that issued stocks appearing in the CRSP common stock database since 1926, just five firms (Exxon Mobile, Apple, Microsoft, General Electric, and International Business Machines) account for 10% of the total wealth creation. The 90 top-performing companies, slightly more than one-third of 1% of the companies that have listed common stock, collectively account for over half of the wealth creation. The 1.092 top-performing companies, slightly more than 4% of the total, account for all of the net wealth 4 creation. That is, the remaining 96% of companies whose common stock has appeared in the CRSP data collectively generate lifetime dollar gains that matched gains on one-month Treasury bills.”

The author confirmed that some level of returns concentration should be expected as some firms have a much larger life than average and because of the monthly positively skewed returns. But nevertheless, the degree of concentration in wealth creation is striking.

Active investing is hard

The results of this study do not dismiss the argument that stocks are the best choice for long-term investors. But they definitely question the pertinence of active investing strategies. We know that most money managers are not able to produce long-term track records that are better than their index of comparison and it is usually attributed, as Smith said, to costs, lack of skill or institutional biases. But it could also be related to the fact that their concentrated portfolios are invested in the wrong sets of companies.

Investing in all of the market, in an index for example, will produce many losers. But it will capture the positive long-term skewness of a limited number of companies that will assure reasonable long-term returns.

If an investor is not confident enough that they can select a group of stocks that will presumably outperform bonds and their indexes of comparison, then they should just buy the index.