Modern investment management is built upon a simple portfolio allocation between stocks and bonds, often starting with a base 60/40 mix between the two and then making adjustments from there. This broad approach to investment management has worked well for generations, but many investors see it as just a starting point, with the real value of investment management focused on managing the specific individual investments that they hold—in other words: stock picking.
As a result of this view, financial advisors and investment managers of all stripes often find themselves under pressure to pick winners or to examine the specific performance of particular investments. This tendency ignores a crucial fact; since 1926, more than half of all stocks have had returns that are lower than what an investor would earn on a one-month treasury bill.That fact is remarkable and underappreciated by investors and managers alike. And it is not an artifact of trading in and out of stocks or some other facet of investor behavior—buy and hold returns for the majority of stocks are lower than what one would earn on a (very) short-term risk-free T-bill. It is not that T-bills themselves are secretly much more lucrative than most investors realize; instead, most stocks simply do not go up much over the long run.
How do we reconcile this reality with the fact that the stock market, on average, rises by about 10.8% annually? The answer is that a small subset of stocks power most of the market’s gains. In fact, the best-performing 4% of stocks account for the entire average return for the market as a whole. Because it’s unknown what that 4% of stocks are going to be in any given year, and they change over time, the result is a feast or famine business when it comes to investing in individual stocks. If we get lucky and happen to hit one of the 4% superstar stocks, then we will do very well if those are a large part of the portfolio. But all else being equal, there is a 24 out of 25 chance that any individual stock is not going to be such a stellar performer. That is not to say that those 24 of 25 stocks are going to be dogs, they just won’t go up much on average over time.
What then, is the implication for investment managers?
If you are going to be an active stock picker, it’s likely to be a high-risk business, so make sure that you are putting focus on research to improve your odds when trying to narrow down that list of 25 stocks.
Regardless of research, you probably won’t be holding those superstar stocks in a non-diversified portfolio, but rather in a diversified portfolio that removes stocks that probably are not going to be part of the 4%. In this case, you can still see significant above-market performance. In other words, you don’t have to find the 4%; you just have to weed out those stocks that are not part of the 4%. Doing that will put you above the market as a whole.
About Us | The SS&C Learning Institute is a division of SS&C dedicated to providing continuing education for today’s professionals. From a library of 250+ online CPE courses to microlearning articles and videos, our offerings are delivered by industry-leading subject matter experts and cover a wide variety of key topics such as ESG investing and digital assets. To learn more about the SS&C Learning Institute, please visit ssctech.com/learn.