Wealth Creation in the US Stock Market
Movies like the Wolf of Wallstreet glamorize the normal dealings of investment firms and active managers. They paint them as wildly successful entrepreneurs and sometimes even horrible scam artists, or a combination of the two. However, the reality is a bit different. It’s commonly known in the investment community that attempting to beat the market is incredibly difficult. However, there’s some new research out suggesting that it’s even harder.
Some research from the Arizona State University’s department of finance has found that from 1926 to 2019 that the majority of stocks did not out perform simple treasury bonds. The study, entitled “Wealth Creation in the U.S. Public Stock Markets 1926 to 2019” by Hendrik Bessembinder, looked at 26,168 firms, all publicity traded since 1926. It found that by and large the majority of stocks actually decreased shareholder’s wealth. 57.8% of stocks led to reduced, rather than increased, shareholder’s wealth. However, despite that terrible record, the stock market on average has increased wealth. Technology firms have accounted for the largest share, $9 trillion, of the total wealth created, $47.7 trillion. However, the degree to which the stock market creates wealth is very concentrated to a small number of firms in each industry, and that concentrated wealth has been increasing over time. Further, within the last 3 years, five firms have accounted for 22% of the net wealth creation in US stock markets.
Implications for investors
The findings are important for investors because they have large implications about stock picking. The results are, you had better be an exception stock picker or else you’re no better off than playing the lottery. For example, the collection of stocks examined by the author shows a great deal of positive skewness. This implies that undiversified portfolios of stocks selected at random will underperform the overall market more often than not. However, these results support the hypothesis that, if you wish to have a chance to out perform the market, even if that chance is minimal, selecting just a handful of stocks is your best bet to outperforming. Further, it also supports the idea that, if there are investors with a “comparative advantage” in picking stocks, they could have potential to deliver outsized long-run returns. Indeed, picking stocks has a very slim chance of producing outsized gains, but if you’re a risk taker, it can pay off. Although, on average the reality is stock picking does not even beat treasury bonds. A stock picker is better off to put that money into a treasury bond than picking stocks.
Further still, a graphic from the paper in reference shows how likely a stock picker needs to be per year in order to pick a stock that is in the top 50% of wealth creators. In 1929, a stock picker would need to have the foresight to pick one of the top 2.63% of firms that accounted for the top 50% of wealth creators. On average, only 2.03% of stocks every year produce the majority of the wealth created in the stock market. Or in other words, a 97.97% chance of picking a stock outside the companies that produce the majority of the wealth. That is absolutely terrible odds.
While the majority of firms lose investors money, some do indeed create tremendous wealth for their shareholders. The best example as of 2019 is Apple, which has created the most wealth for investors since 1926 with a total wealth creation of $1.64 trillion. The next competitors are Microsoft (created $1.41 trillion), Exxon Mobil (created $988 billion), Amazon (created $865 billion), and Alphabet (created $718 billion). Out of those examples, the only company that has existed since 1926 is Exxon Mobil. Technology firms have produced the biggest net wealth creation by industry. Although, Apple and these other technology firms have created a tremendous amount of wealth within a short period of time, 3 years. And by comparison some firms that were ranked near the top in wealth creation, like General Electric stumbled. General Electric had created a total of $608 billion in 2016 but dropped to $461 billion by 2019. This show cases how quickly firms can lose value and lose investor’s money along the way.
In summary, you are more likely to buy an IPO which under performs Treasury Bonds for its entire publicly traded lifetime than you are to pick one that beats T-bills. These are also T-bills we are talking about as a benchmark, an asset that is yielding 0.03% today. In other words, that IPO a stock picker is thinking of picking up, is more likely to destroy wealth than create it. This helps the investment community to understand a interesting phenomenon, as the author puts it, “The results also help to explain why active strategies, which tend to be poorly diversified, most often underperform,” Hendrik Bessembinder of Arizona State University. “The 1,000 top performing stocks, less than 4 percent of the total, account for all of the wealth creation,” according to the study. “That is, the other 96 percent of stocks that have appeared on (securities return database) collectively generated lifetime dollar returns that only match the one-month Treasury bill.”
When stock pickers begin to attempt to pick stock, they are taking on huge asymmetrical risks and with only a tiny chance to outperform. But this study comes as a good time to help combat the idea that stock picking is a good idea. Many active investors are arguing again in favor of active strategies and active funds some of which have had tremendous success within the last year or so – like ARKK. But even despite some out performers, the hard evidence is clear, stock picking is a loser’s game. If you wish to hunt for the next Amazon, go for it. But I wouldn’t expect a happy retirement or happy clients. The only way to get outsized gains in the market, is to take on more risk, through leverage or uncompensated risk with a concentrated portfolio. However, if you’re trying to build wealth and want to invest, try using m1 finance (you’ll get an extra $30 dollars with the referral link) it’s a great platform for long term investing. And finally, if you’re looking for further ways to enhance returns check out our high risk and ultra-high risk newsletter.
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