When we discuss stock returns, most individuals assume that individual stocks should produce positive returns. That’s since the stock market has historically outperformed other asset classes like bonds. But surprisingly, the median return for a big sample of individual stocks is – drumroll, please – zero. That’s right. A study conducted by Henric Bessembinder and published in April 2023 found that individual stocks generate returns which might be roughly zero on a monthly basis. In fact, this can be a “half full, half empty” scenario. Half of the stocks generate positive returns while the opposite half have negative returns.
How do you and your clients react to this as an investor or advisor? If this zero median return statistic were the one method to take a look at stock performance, it could be difficult to justify investing in stocks in any respect. Convincing customers to take a position in stocks can be an uphill battle, especially in the event that they are in search of short-term gains.
Volatility
In fact, there are lots of ways to judge stock returns beyond just specializing in average monthly performance. A typical approach is to measure stock returns using. Volatility is how much a stock’s price fluctuates and is commonly measured by standard deviation. On average, the annual standard deviation of stock returns is about 50%, meaning the worth of a single stock can fluctuate widely all year long. If we apply the 95 percent confidence interval often utilized in statistics, which means the return of a single stock can vary by about +/- 100% in a given yr. This is big. Essentially, a single stock could double in value or lose it entirely inside 12 months.
This level of uncertainty could make stocks seem daunting, especially for those looking for stability. The concept that individual stocks are “half full, half empty” on a monthly basis and much more volatile on an annual basis may be off-putting to potential investors. However, it will be significant to do not forget that stocks are primarily intended as long-term investments.
The short-term ups and downs, while nerve-wracking, are a part of the trail to long-term wealth creation.
So what happens after we shift our focus to long-term individual stock returns? Shouldn’t we expect more consistency over time? Bessembinder also examined long-term stock performance, and the outcomes weren’t exactly reassuring. Over the long run, 55% of U.S. stocks underperformed Treasury yields, meaning greater than half of individual stocks underperformed the safest government-sponsored investments. Perhaps much more concerning is the indisputable fact that probably the most common final result for individual stocks has been a 100% loss – an entire failure. These results suggest that investing in individual stocks is a dangerous endeavor, even when taking a long-term approach.
When investors and financial analysts evaluate the performance of stocks, they typically give attention to two key statistical measures: (e.g. the mean or mean return) and (measured by standard deviation). This traditional method of study often creates a negative or not less than discouraging narrative about investing in individual stocks.
If returns are largely zero within the short term, very volatile within the medium term and dangerous in the long run, why would anyone put money into stocks?
The answer, as history shows, is that despite these challenges, stocks have significantly outperformed other asset classes resembling bonds and money over longer periods of time. But to really understand why, we’d like to look beyond the everyday first two parameters used when analyzing stock returns.
The third parameter for assessing stock performance: positive skew
While traditional evaluation focuses heavily on the primary two parameters – central value and volatility – it misses an important component of stock returns: . Positive skew is the third parameter of the stock return distribution and is essential to explaining why stocks have historically outperformed other investments. If we only give attention to core value and volatility, we’re essentially assuming that stock returns follow a standard distribution, just like a bell curve. This assumption works well for a lot of natural phenomena, but doesn’t apply to stock returns.
Why not? Because stock returns aren’t subject to the laws of nature; They are driven by the actions of individuals, who are sometimes irrational and driven by emotions. Unlike natural events, which follow predictable patterns, stock prices are the results of complex human behavior – fear, greed, speculation, optimism and panic. This emotional backdrop signifies that stock prices can skyrocket dramatically if the masses get carried away, but can only fall to a limit of -100% (when a stock loses all of its value). This results in a positive distortion of stock returns.
Put simply, while a stock’s downside potential is restricted to a 100% loss, its upside potential is theoretically unlimited. An investor could lose all of their money on one stock while one other stock could skyrocket and gain 200%, 500%, or much more.
The very indisputable fact that profits can far exceed losses results in a positive bias.
This skewness, coupled with the magic of multi-period compounding, explains much of the long-term value of investing in stocks.
Learn to tolerate tail events
If you take a look at stock return distributions, you will see that the long-term value of investing out there comes primarily from the “tail.” These are the rare but extreme outcomes that occur at each ends of the distribution. The long, positive tail is what produces the outsized returns that greater than offset the smaller, frequent losses. For stocks to have produced the high returns now we have seen up to now, the massive positive extreme events will need to have outweighed the massive negative ones.
The more positive the return distribution, the upper the long-term returns.
This may sound counterintuitive at first, especially when traditional portfolio management strategies give attention to eliminating volatility. Portfolio construction is commonly about how you can reduce the chance of maximum events, each positive and negative.
The goal is to create a more predictable and fewer volatile stream of returns that may feel safer for investors. However, by avoiding these troubling events, investors eliminate each the massive losses and the massive gains. This reduces the positive skew and, in consequence, drastically reduces the whole return.
The hidden costs of managed equity
A typical managed equity strategy eliminates all equity losses (no return below zero) while limiting upside returns. For example, a widely known investment company offers a managed S&P 500 fund that avoids all annual losses while limiting returns to lower than 7%. Since it’s virtually unattainable to predict every day returns, this return performance is achieved just by holding a free S&P 500 options collar. Over the last 40-plus years, when the S&P 500 returned greater than 11% annually, this strategy would have produced a paltry 4% annual return.
In other words, in case you avoid extreme emotional events, you miss out on the very returns which might be the foremost drivers of long-term wealth creation. Investors who focus an excessive amount of on smoothing returns experience more consistent but dramatically lower returns over time.
To truly profit from stock investing, it’s vital to embrace each the emotions and rewards that include a positive bias. That means . They could also be unpleasant once they occur, but they’re a vital a part of long-term success within the stock market.
The most successful investors recognize this and accept that volatility and inevitable tail events are critical to achieving high returns. By learning to understand positive skew and associated tail events, investors can realize the total potential of stock market gains.
Learn to like and do not be afraid of the distortion.
