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Equities Beat Cash – Really?

Hendrik Bessembinder interprets the performance of US stocks since 1926 in a recent study. It shows why a broad diversification of equities can do more than just reduce risks and why active asset management is beneficial.

A recent study by Hendrik Bessembinder, soon to be published in the renowned Journal of Financial Economics, examines the performance of American stocks since 1926.The author mentions at least three interesting points to ponder.

First, he raises the question of whether US stocks really did outperform risk-free money market investments. Bessembinder finds that the excess return for the entire US stock market can be explained by the best-performing 4% of listed companies! The remaining 96% generated, on balance, no excess returns. In other words, if one had invested 4% in the best-performing stocks in 1926, and held the remaining 96% in money market investments, one would have gained exactly the same amount today as someone who invested 100% in the stock index in 1926. The author’s astonishing conclusion is that broad equity diversification not only serves to reduce risk, it also ensures that the best-performing 4% of companies are indeed represented in the portfolio.

Equities Do Not Always Mean Higher Interest Rates

Second, Bessembinder asserts that only 42.6% of the stocks that he examined deliver a long-term outperformance of the risk-free interest rate. This too is an indicator that equities across the board do not represent a good investment – only selected outperforming shares do. In a nutshell: active asset management creates good opportunities to generate alpha.

Third, I find the following thought experiment interesting: imagine that you had already known in 1926 that General Motors (GM) would go bankrupt in 2009 and that the shares would lose their entire value. Would the best strategy have been to shun GM shares? No, because over the years GM paid out USD 64 billion in dividends, making it one of the best-performing shares in American history – despite the complete write-off at the end.

Tracking Trends Increases Chances of Profit

So, what is the “moral” of the study? A disciplined, active asset management strategy has a better chance of success than a haphazard or buy-and-hold approach. But the study highlights – ironically – that the many managers pursuing portfolio concentration may be on the wrong track. Why? Let’s consider another study, by Inalytics. They conclude that the average number of shares in active equity funds has fallen from 121 to 61 over the last ten years. The risk attending such attempts to use selectivity to overweight the “winners” is that it may miss the actual market superstars.

According to Bessembinder, successful asset managers do not hold the market minus the “losers”, but rather the market plus the “winners”! The point is to be proactive in ensuring that one does not miss new trends simply because they are not yet indexed.