Most stockmarket returns come from a tiny fraction of shares
IN his book about the use of language, “The King’s English”, Kingsley Amis describes a tug-of-war. On one side are “berks”, careless and coarse, who would destroy the language by polluting it. On the other side are priggish “wankers”, who would destroy it by sterilisation.
The battle lines look similar in investment. The divide is not on points of grammar but on attitudes towards a handful of modish companies, known as FAANG. These stocks (Facebook, Amazon, Apple, Netflix and Google) have been the motor of the S&P 500 (see chart). All but Apple hit record highs on June 20th. Fill your boots is the attitude of coarse stockmarket berks. FAANG makes more sense than stocks in dying industries. For the prigs, the mania for FAANG stocks is as abhorrent as a split infinitive. The high-minded investor stands apart from the herd.
In matters of grammar, the unsure often follow the sticklers. They at least have rules. But they are often too rigid. Stockmarket sticklers can similarly lead others astray. For most investors, it is often a mistake to shun individual stocks simply because other people are keen on them.
A recent paper* by Hendrik Bessembinder of Arizona State University explains why. Since 1926, most stockmarket returns in America have come from a tiny fraction of shares. Just five stocks (Apple, ExxonMobil, Microsoft, GE and IBM) accounted for a tenth of all the wealth created for shareholders between 1926 and 2016. The top 50 stocks account for two-fifths of the total. More than half the 25,000 or so stocks listed in America in the past 90 years proved to be worse investments than Treasury bills.
The sway that FAANG stocks have held recently is not out of the ordinary. A new report by analysts at Macquarie, a bank, find that the clout of leading stocks in the S&P 500 has often been higher in the past. Mr Bessembinder’s results complement the verdict of another strain of research, which says that most stock returns are made on relatively few trading days. Just as it is important not to be out of the market on those days, it is important not to omit key stocks from your portfolio.
Double or nothing
To understand why, it helps to think of investing as a game of chance. Imagine there is an equal chance that a stock will rise or fall by 50% each year. A $ 100 stock that goes up 50% in year one would be worth $ 150; if it falls by 50% in year two, it is worth $ 75, less than when the game started. In contrast, a lucky stock that rises by 50% in two successive rounds is worth $ 225. After many rounds, most stocks lose money. But a few stocks make a lot of it.
It would be foolish, though, to take this as cue to invest solely in FAANG. There is no guarantee that today’s winners will still be winners tomorrow. Sticklers will rightly point out that if you overpay for a stream of earnings, however good the company is, you cannot hope to make money from investing. Are modish stocks a trap, then? It might seem so. The “Nifty Fifty”, a group of popular (and thus expensive) stocks in the late 1960s, fell hardest in the bear market of the 1970s. Then again, many of them—GE, IBM, Johnson & Johnson, Coca Cola and so on—are also on Mr Bessembinder’s list of the 50 biggest wealth creators. To have bought and sold them at the right moments required deft timing.
Wise investors who do not know how to pick tomorrow’s winners, or how to time markets, opt to hold a broad index of stocks passively. Even this approach has drawbacks. Bull markets tend to narrow, says Robert Buckland, of Citigroup, because of rising pressure on fund managers to buy the recent winners. “A bubble is what I get fired for not owning,” one told Mr Buckland. The stockmarket index thus tilts ever more heavily towards a few shares. And these may not turn out to be the big winners in the long term.
The best defence is to diversify broadly across markets and assets as well as stocks. That includes bonds and cash, of course. Another way to offset a concentration of a certain kind of stock is to invest in equity markets outside America. The euro zone’s indices, for instance, have a far lower weight in technology companies. You won’t avoid a crash in modish stocks, should one occur. But at least you will be able to survive it.
Such a middle-of-the-road approach might appear to lack personality. It is more distinctive to be a stickler for convention or a flouter of it. Yet it is the right approach—and it works for language, too. English survives and prospers because most of its users are neither style sticklers nor utterly slapdash.
*“Do Stocks Outperform Treasury Bills?” Forthcoming, Journal of Financial Economics (2018)
This article appeared in the Finance and economics section of the print edition under the headline “The lucky few”
