To news & knowledge overview

Pearl hunting with Pareto

 Salomons Judgement

The average share doesn’t exist. New research shows that only a handful of shares is responsible for the average return. Bad luck if you didn’t have those.

Last week marked the end of the academic year, the moment to put students in the spotlight. This traditionally takes place with great display in the auditorium where I defended my research into the risk premium on financial markets over ten years ago. In the long term, shares will yield more than bonds or cash holdings. How much exactly is something that has occupied investors and academics for years.

I’m still interested in this issue now. Recently published research sheds new light on the historical compensation. In an article that will appear shortly in the Journal of Financial Economics, Hendrik Bessembinder calculates that only five companies (Apple, Exxon, Microsoft, GE and IBM) are responsible for 10% of the total value creation in US stocks since 1926. The fifty best-performing shares define 40% of the total return.

The best data point is that more than half of the approximately 25,000 shares listed on the American stock exchange since 1926 were a worse investment than cash (actually T-bills, but that’s for the gourmets).

Similar studies have been conducted into whether or not being present in the market on crucial trading days makes a difference. I will do some serious research into this at some time, as the figures circulating on the internet seem to be unreliable. Let’s just say that by missing out on the ten best days investing in equity still beats cash, but by a much smaller margin.

The problem with such sums is that you can also omit the ten worst days, because without the ten best and the ten worst days the return is comparable again to a buy and hold portfolio. It’s extremely difficult to pick the right time to be in and out of the market. The best and worst days are also ‘coincidentally’ close to each other. Check out the yearbooks of 1929, 1931, 1933 and 2008.

The Italian economist Vilfredo Pareto found that 20% of the bean plants in his garden accounted for 80% of the harvest. He went on to investigate and discovered that 80% of the country in Italy was owned by 20% of the people. The same rule applies to yields on the American stock exchange. Whether or not to have a handful of shares results in a large difference in returns. It is just even more extreme than what Pareto thought when he studied his plants and laid the foundation for what is called the Pareto principle.

The same principle applies to investors. We already knew about the returns over time, but it also applies to the structure of the shares. The conclusion from the above-mentioned studies is that returns are not regular but misaligned to the right and with fat tails. Especially the outliers on the right side of the distribution are important. A lack of real outliers causes many investors to perform slightly below average. The lesson for them is simple: focus as active investors on finding the true pearls. Or go for an optimum distribution. Everything in between is a waste of time and money.

The author

Roelof Salomons

Subscribe to our letter

Leave your email address and be the first to receive the latest editions

News & Knowledge