4% of Stocks Created Wealth

4% of Stocks Created Wealth 

By James Parkyn - PWL Capital - Montreal

How to ensure you own tomorrow’s winners  

It’s well known that owning stocks can generate great returns over the long run. Less known is the fact that almost all of that wealth creation typically comes from a tiny number of stocks. 

New research shows that $1 invested in the U.S. stock market in 1926 would have grown to an impressive $229.40 by 2023. That’s a cumulative compound return of 22,840%.  

Even more remarkable, however, is that just 4% of stocks accounted for all stock market wealth creation above a risk-free investment in Treasury bills. In fact, a majority of stocks—51.6% to be exact—actually had negative compound returns from 1926 to 2023. In other words, slightly more than half of stocks lost money over their life. 

The median stock lost 7.41%  

These are some of the fascinating conclusions of Arizona State University economist Hendrik Bessembinder.  

In a new paper, Bessembinder analyzed the retrns of 29,078 publicly listed common stocks from 1926 to 2023. His findings give powerful support for investing strategies that focus on passively owning a broadly diversified portfolio of stocks with a long-term horizon—the approach we use at PWL. 

Here are some of Bessembinder’s other conclusions: 

• Companies remained publicly listed for only 11.6 years on average.  

• Just 31 stocks remained publicly listed in the database for the full 98 years.  

• The median cumulative compound return of all the stocks was -7.41% per year.  

Top performer gained 266 million percent 

How is it possible for the median return to be negative when the mean compound return was 22,840%? This is because of the magic of averaging. The mean average return is skewed heavily upward by massive gains of a small number of companies. These are the companies it’s essential to own for our investments to make money. 

As Bessembinder put it in a recent interview, “Long-run wealth enhancement in the public stock market is concentrated in relatively few stocks.” 

Among the best 30 performers: Emerson Electric Co., in 30th place, with a cumulative return of 2.4 million percent, and top dog Altria Group (formerly Philip Morris), with an otherworldly 266 million percent gain.  

Those aren’t typos. Stated differently, $1 invested in Emerson Electric would have become $24,098, while a dollar invested in Altria/Philip Morris stock would have grown to $2.66 million. 

Compounding led to massive profits 

These astonishing profits, incidentally, show the value of patiently accumulating compounded returns over the long run.  

Interestingly, Emerson Electric made its gains with what Bessembinder calls only a “moderately high” annualized compound return of 13.57%. The key was 79 years of compounding at this rate.  

Altria, for its part, had only a somewhat higher annualized compound return of 16.29%. But when compounded over 98 years, this yielded an extraordinary gain.  

Five firms accounted for 11.9% of gains   

Bessembinder’s findings confirm his earlier landmark research in which he found that just five of 26,168 publicly listed firms accounted for 11.9% of net U.S. shareholder wealth creation of $47.38 trillion from 1926 to 2019. 

This concentration is increasing. In 2016-2019, just five firms accounted for an even bigger slice—22.1%—of shareholder wealth creation. 

“This tendency for wealth creation to be concentrated in a few stocks has grown even stronger in recent years,” Bessembinder recently said. 

How to own the next winners  

What does all this mean? A tiny number of stocks is responsible for almost all wealth gain in the stock market. If you didn’t own those stocks, you would have lost money. How do you know which stocks to buy? You don’t. No one can know in advance which companies will be the best performers.  

The answer is not to gamble your savings and legacy on trying to find the hot new trend of the day, but to be sure you own the next Altria, Emerson or Google by owning every stock. This can be accomplished through broad index funds that hold all the companies in various market indexes, such as the S&P 500 Index or S&P/TSX Composite Index. 

As Bessembinder put it, “The only way to be certain of owning the stocks that turn out to be the future big gainers is to own all the stocks” in a broad index fund.  

At PWL, we couldn’t agree more. This is the approach that is at the core of our data-driven strategy focused on the long term. 

Fads and companies come and go, but a disciplined approach of owning the entire market ensures you’ll benefit from the winning companies of the next 98 years. 

Read more commentary and insights on personal finance and investing in our past blog posts, eBooks and podcast on the website of PWL Capital’s Parkyn-Doyon La Rochelle team and on our Capital Topics website.   

TAKE ADVANTAGE OF THE EXPERTISE OF JAMES PARKYN, Portfolio Manager at PWL Capital Montreal to determine the best solution for you.

Is 100% stocks really the best option for your portfolio ?

Is 100% stocks really the best option for your portfolio ?

By James Parkyn

Much of the investing world looks at bonds as the “safe” portion of an investment portfolio, a bulwark against the volatility in the stock market. Hence, you have popular asset allocation strategies like the 60/40 balanced portfolio and target date funds that increase bond exposure as investors get older.

However, recent research calls into question the traditional view of bonds and it’s attracting a lot of attention. The research by three U.S. finance professors led by University of Arizona professor Scott Cederberg comes to the surprising conclusion that a portfolio holding 100% stocks and no bonds is best, even for people already in retirement.

That’s certainly an eye-catching conclusion, but one that comes with many important nuances.

The researchers studied data from 39 developed countries over 130 years of returns from stocks, bonds and treasury bills as well as inflation.

In the first of three papers based on this database, the authors show that while stocks are risky—the probability of losing money in real terms (net of inflation) is 12% after 30 years—bonds and treasury bills are even riskier. Across the 39 countries, the probability of losing money on treasury bills was 37%, and on intermediate-term government bonds 27%.

In the second paper, the researchers found that while stocks were the least risky investment over the long term, adding international stocks to the mix reduced the riskiness significantly. In fact, for a portfolio composed only of domestic stocks, the probability of losing money net of inflation over 30 years was 13%, but if you add 50% international stocks, the probability of losing money drops to 4%.

The third and most recent paper was the most interesting for us. In it, the professors simulated the financial lives of 1 million couples – from 39 countries – who start saving 10% of their salary from the age of 25 until their retirement at 65.

Upon retirement, they withdraw 4% of their savings, indexed to inflation, until the death of the last spouse. The simulations take into account, in addition to market fluctuations, mortality risk and the risk of job loss. They also take account of old age pensions such as Social Security, the U.S. equivalent of our Old Age Security in Canada.

The researchers—Scott Cederburg, Aizhan Anarkulova and Michael O’Doherty—compared five investment strategies over the lifetime of the couples:

• 100% treasury bills

• 60/40 balanced portfolio

• 100% stock allocation at age 25 and gradually reducing stocks in favour of bonds over the years

• 100% domestic stocks

• 50% domestic stocks / 50% international stocks

The success of each of these strategies was evaluated on a number of criteria, including, most importantly, the couples’ risk of outliving their money.

An internationally diversified portfolio of stocks turned out to be the least risky strategy, both before and after retirement, even though a 100% stock portfolio did expose couples to the greatest risk of a drop in wealth that may be temporary or last several years.

What explains the superior performance of the 100% international equity portfolio?

• Stocks have a much higher expected return than treasury bills and bonds. The authors estimate real expected stock returns to be four times those of bonds.

• After a period of decline, stocks tend to rebound. By contrast, bonds tend to continue to fall because inflation persists.

• International stocks provide protection against domestic inflation.

• In the long run, stock and bond returns have a fairly high correlation of 0.5. Thus, over the long term, bonds offer little protection against poor stock market returns.

So, what to make of the findings? First, they are a clear confirmation that an internationally diversified stock portfolio beats one that is concentrated in domestic stocks.

Second, it’s crucial to remember that these financial simulations assumed the couples were perfectly rational even in the midst of major market declines. In the real world, emotions all too often derail the best intentions of investors.

Many investors—especially those in retirement or close to it—will have a hard time watching their all-stock portfolio sink in a bear market by 40% or more, even if they understand intellectually that stock markets bounce back over time. The danger of panicking and selling at just the wrong moment is real.

The authors are not claiming that equities are “safe” investments. Instead, they are saying you need the higher returns they provide to continue accumulating wealth even in retirement to avoid outliving your money in an era when many people are living to over 90 years old. 

The research provides good food for thought about the optimal asset allocation. And, above all, it reinforces the importance of having an experienced investment advisor to guide you in making decisions and sticking with your financial plan through good times and bad.

In the next episode of our Capital Topics podcast, we take a closer look at this fascinating research with PWL Capital Senior Researcher Raymond Kerzérho, who also gives us an update on our latest estimates of future asset class returns. Be sure to download the podcast and subscribe to never miss an episode.

Our best investment advice of 2023

Our best investment advice of 2023

By James Parkyn

This year has been one of recovery in the markets. But to benefit, you had to once again remain patient and keep a long-term perspective, especially through a sharp pullback in the markets this fall.

Through much of the year interest rates continued to rise as central banks kept up their battle against inflation. Then, with progress being made on inflation and the North American economy remaining surprisingly resilient, investor hopes for a soft economic landing and lower rates in 2024 began to rise. That sparked an impressive rally in the stock market in the final months of the year.

As 2023 comes to a close, we wanted to look back at some of our most popular blog posts.

1. The silver lining of a tough year in the markets is higher expected returns—2022 was an especially painful one for investors with both the stock and bond markets falling by double-digit percentages. The good news is that those declines led to a substantial improvement in future long-term expected returns. Higher bond yields were especially welcome for investors who have experienced nearly 15 years of ultra-low yields, including periods when they didn’t even keep pace with inflation.

   In PWL Capital’s latest Financial Planning Assumptions, our estimate for expected annual bond returns jumped to 4.19% from 2.48% at the end of 2021. Our expected return for a broadly diversified 60/40 stock/bond portfolio rose to 5.75% from 4.97%. The improvement could allow investors to reduce the riskiness of their portfolio while still achieving their financial goals, as I discuss in this post.

2. Here’s a better way to think about risk—When academics and professional investors talk about risk, they usually refer to technical concepts like volatility and standard deviation. But in an essay entitled Five Things I Know About Investing, famed finance professor Kenneth French proposes a simpler definition – risk is uncertainty about how much wealth it will take to achieve your lifetime goals. In light of this definition, I turned to one of our favourite authors, Morgan Housel. In his book, The Psychology of Money, Housel says risk is unavoidable because the future is unknowable, but you can take steps to put the odds on your side.

   • Don’t take risks that will deplete your wealth and prevent you from benefitting from the power of compounding over the long term.

   • Be prepared for things not to go as planned. You only have to think about the pandemic, the war in Ukraine or rising interest rates to know you should expect the unexpected. According to Housel, preparation can be in many forms: “A frugal budget, flexible thinking and a loose timeline – anything that lets you live happily with a range of outcomes.

   • Cultivate a “barbell personality”—be optimistic about the future, but paranoid about what will prevent you from getting there. Sensible optimism is a belief that odds are in your favour for things to work out over time even if you know there will be difficulties along the way. To make it to that optimistic future, you have to make prudent decisions and stay the course when things are looking bleak.

3. Why too much exposure to Canadian stocks hurts your portfolio—According to a report from Vanguard, Canadian stocks represent just 3.4% of the global equities market, but Canadian investors allocate 52.2% of the equity portion of their portfolio to Canadian stocks, a 15-to-1 mismatch.

    That kind of home bias can be found in other countries and is a serious impediment to portfolio diversification, which is the key to reducing risk. In Canada, the problem is made worse by the concentration of our market. The top 10 stocks represent nearly 37% of the Canadian index and the market is heavily overweighted in financial services (+16.4%), energy (+12.1%) and materials (+7.2%) as compared to the global market, and underweighted in information technology (-13.0%), health care (-11.7%) and consumer discretionary (-7.3%). As a result, the Canadian market has historically been more volatile than the global market without a proportionate increase in return. That’s a bad deal for investors and the obvious reason why you need a substantial quantity of global stocks to your portfolio mix.

4. Young people need to grow both their financial and human capital—This year we launched a new eBook, Investing Life Skills for Early Savers, that covers key investing concepts in a format that’s accessible and relevant for young people.

   One of the seven concepts included in the book is the importance of managing your human capital. While it gets very little attention in the media, this is of critical importance, especially for young people. Human capital is your potential to generate income over your lifetime. It can be defined as the present value of all future income from working and, for most people, it’s their most valuable asset. For young people, it represents a huge number and is even more valuable because it’s hedged against inflation because wages tend to rise over time.

   You can increase your human capital through education, training and cultivating interpersonal skills. You also need to protect it with tools like disability insurance. As you move through your career, your goal should be to convert your human capital into financial capital by earning, saving and making good investment decisions.

   If you haven’t already done so be sure to download your free copy of Investing Life Skills for Early Savers.

For more advice on investing and personal finance, subscribe to our Capital Topics podcast and download another of our popular eBooks, Seven Deadly Sins of Investing.

We hope you are enjoying a restful and joyous holiday season and the whole team joins in wishing you a healthy and prosperous 2024.

Is it time to dial back risk in your portfolio?

Is it time to dial back risk in your portfolio?

By James Parkyn

Earlier this year, I discussed how a painful 2022 in the markets created a much brighter picture for long-term investors going forward.

Double-digit losses in both the stock and bond markets last year led to an important gain in future expected investment returns.

The improvement in bond yields has been especially impressive for investors who lived through close to 15 years of ultra-low yields, including periods when they didn’t even keep pace with inflation. During that time, many investors increased the equity allocation in their portfolio to make up for anemic bond returns—accepting more risk in search of higher returns from the stock market.

The strategy worked for those who could stomach periods of volatility and stay invested. Despite some setbacks, including the sharp but mercifully short pandemic bear market in 2020, stocks produced excellent returns from the financial crisis of 2008-09 through 2021.

Now, the picture has changed. Fixed-income securities are yielding nearly 5% and the question becomes: Is it time to move money from stocks to fixed income to take advantage of the higher yields and reduce risk?

Yields in the 5% range weren’t unusual before the financial crisis and, without predicting the future direction of interest rates, current action in the bond market suggests they will remain higher for longer than many economists had predicted.

In PWL Capital’s latest Financial Planning Assumptions, our estimate for expected annual bond returns jumped to 4.19% from 2.48% at the end of 2021. Our expected return for a broadly diversified 60/40 stock/bond portfolio rose to 5.75% from 4.97%.

As I noted earlier this year, in estimating returns, our research team doesn’t pretend to know what will happen in the markets in advance. Instead, they take the average of all possible return scenarios for a broadly diversified portfolio of publicly traded investments over a 30-year time horizon. Of course, returns in any given year can vary widely from the estimates.

This article argues that investors tempted by high yields should be careful not to short-circuit their long-term investment plan by forgoing higher expected returns offered by stocks.

“Stocks, which carry a risk premium to compensate for added volatility, will beat bonds over time, and bonds, which earn extra yield from taking term and credit risk, will beat secure, short-term vehicles such as GICs,” writes investment manager Tom Bradley.

Nevertheless, the emergence of higher interest rates marks an important shift. Changing your asset mix should never be done lightly or based on temporary economic, geopolitical or market developments. Instead, it should be executed as part of a comprehensive financial plan that considers your financial and personal situation, your investment knowledge, objectives and needs, your time horizon and your risk tolerance and capacity.

However, if the evolution of fixed-income yields allows you to achieve your goals while reducing the riskiness of your portfolio, it’s an option you should seriously consider with your investment advisor.  

For more commentary and insights on investing and personal finance, be sure to listen to our latest Capital Topics podcast and subscribe to never miss an episode.

How equity premiums improve your expected investment returns

How equity premiums improve your expected investment returns

By James Parkyn

At PWL Capital, we take an evidence-based approach to investing that relies on peer-reviewed research by leading academics who have drawn insights from decades of market data.

At the core of our approach is a large body of research that shows a broadly diversified portfolio of passively managed investments is the best way to capture market returns with the lowest possible risk.

To achieve this, we construct globally diversified portfolios using low-cost index funds that reflect the risk tolerance of our individual clients. We then rebalance them periodically to bring asset weightings back to agreed targets.

Another aspect of our approach is to tilt equity portfolios toward factors that have been shown to produce greater expected returns.

Factors expected to produce premium returns over time are as follows:

• Market premium: Stocks tend to outperform risk-free government bonds (short-term U.S. Treasury bills).

• Size premium: Small stocks tend to outperform large stocks.

• Value premium: Value stocks tend to outperform growth stocks.

• Profitability premium: Stocks of highly profitable companies tend to outperform those of companies with low profits.

A recent paper from Dimensional Fund Advisors looked at how these equity premiums have performed over 10 years to the end of 2022. (Dimensional is a fund manager that uses financial science to add value to fund performance, including by emphasizing the factors listed above. We use select Dimensional funds in our portfolios.)

The Dimensional paper found that in the 10-year period to the end of 2022, high-profitability stocks generally outperformed low profitability stocks and small cap stocks outperformed large caps outside the U.S.

The group of stocks that underperformed globally during the decade was value, a fact that’s attracted a lot of attention from market observers. Despite a strong rebound from late 2020 through 2022, the MSCI world value index delivered a 7.25% annualized return versus 8.49% for MSCI’s total market world index.

The paper observes that it’s not uncommon for one premium factor to underperform over a 10-year period. However, in looking at data back to 1963, it’s much rarer for two of them to underperform over that length of time and there are no instances when three or four underperformed the market.  

It notes that “while a positive premium is never guaranteed, the odds of realizing one are decidedly in your favour and improve the longer you stay invested…Furthermore, premiums can materialize quickly, so you want to be properly positioned to capture the returns when they show up.”

A recent article by our colleague Raymond Kerzérho reminded us of the importance of capturing returns from small cap stocks as part of a fully diversified equity portfolio.

Raymond, Senior Researcher and Head of Shared Services Research at PWL, looked at the performance of funds that track the total U.S. market index versus those that track the S&P 500. The key difference between the two is that the CRSP Total Market Index holds over 3,800 U.S. stocks, including small- and mid-cap equities, while the S&P 500 holds roughly 500 large-cap stocks.

Since the launch of the S&P 500 Index in March 1957 to June 2023, the total market index has outperformed the S&P 500 by a very small margin of 0.03%. The CRSP Index returned 10.48% while the S&P500 returned 10.45% on an annualized basis.

Despite this small difference in performance, we know that adding small-cap stocks to your portfolio not only adds diversification but increases its expected return going forward. This is a key reason why we use the Vanguard U.S. Total Market ETF in client portfolios.

What’s more, as Raymond writes in his article: “…at the margin, a small number of winning stocks explains the long-term market performance; thus, we prefer not to miss out on these stocks.” By including small-cap and mid-cap stocks, you increase the odds of holding the companies that grow into the next large-cap winners.

“The risk of missing out on the high return stocks was highlighted in 2020 when the S&P 500 Index committee failed to include Tesla’s shares in the index until December after the share’s price had increased by 400%,” Raymond writes.  

We tilt portfolios to capture equity premiums as part of our commitment to adding value to client portfolios. Over the long term, even small gains can make a significant difference to your wealth.

For more insights on passive investing and personal finance, download the latest episode of our Capital Topics podcast and subscribe to never miss an episode. Be sure to also download your free copy of our popular eBook The Seven Deadly Sins of Investing.