The Arizona State professor delves into his provocative finding that most stocks have underperformed cash over time and the implications for investors’ portfolios.
Our guest this week is Dr. Hendrik Bessembinder. Hank is the professor in Francis J. and Mary B. Labriola Chair in Competitive Business at Arizona State University’s Department of Finance. Prof. Bessembinder’s research focuses on market design and trading, including stock, foreign exchange, fixed income, futures, and energy markets, as well as on measuring long-term investment performance. He’s published numerous articles in the Journal of Finance, Journal of Financial Economics, and Review of Financial Studies, among others.
In today’s conversation, we’ll focus on the most widely cited and influential of Prof. Bessembinder’s papers, which is entitled, Do Stocks Outperform Treasury Bills? The paper’s key findings could have implications for stock investors of all stripes. So, we were excited to talk to Hank and dig into his work. You can find this paper and other follow-on work that Hank has done on SSRN and we’ll link to it in the show notes.
Background
Research
“Do Stocks Outperform Treasury Bills?” by Hendrik Bessembinder, ssrn.com, June 3, 2018.
“Wealth Creation in the US Public Stock Markets 1926 to 2019,” by Hendrik Bessembinder, ssrn.com, Feb. 13, 2020.
“Which US Stocks Generated the Highest Long-Term Returns,” by Hendrik Bessembinder, ssrn.com, July 22, 2024.
“Long-Horizon Stock Returns Are Positively Skewed,” by Adam Farago and Erik Hjalmarsson, Review of Finance, April 6, 2022.
“Why Has IPO Underpricing Changed Over Time?” by Tim Loughran and Jay Ritter, Financial Management Journal, Autumn 2004.
“Long-Run Stock Market Returns: Probabilities of Big Gains and Post-Event Returns,” by Hendrik Bessembinder, ssrn.com, Dec. 27, 2021.
“Extreme Stock Market Performers, Part I: Expect Some Drawdowns,” by Hendrik Bessembinder, ssrn.com, July 21, 2020.
“Shareholder Wealth Enhancement, 1926 to 2022,” by Hendrik Bessembinder, ssrn.com, June 17, 2023.
“Long-Term Shareholder Returns: Evidence From 64,000 Global Stocks,” by Hendrik Bessembinder, Te-Feng Chen, Goeun Choi, and K.C. John Wei, ssrn.com, March 6, 2023.
“Predictable Corporate Distributions and Stock Returns,” by Hendrik Bessembinder, ssrn.com, Nov. 24, 2014.
Other
Center for Research in Security Prices (CRSP)
“What Is Jensen’s Measure (Alpha), and How Is It Calculated?” by James Chen, Investopedia.com, July 1, 2024.
Jeffrey Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer at Morningstar Research Services.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning at Morningstar.
Ptak: Our guest this week is Dr. Hendrik Bessembinder. Hank is the professor in Francis J. and Mary B. Labriola Chair in Competitive Business at Arizona State University’s Department of Finance. Prof. Bessembinder’s research focuses on market design and trading, including stock, foreign exchange, fixed income, futures, and energy markets, as well as on measuring long-term investment performance. He’s published numerous articles in the Journal of Finance, Journal of Financial Economics, and Review of Financial Studies, among others.
In today’s conversation, we’ll focus on the most widely cited and influential of Prof. Bessembinder’s papers, which is entitled, Do Stocks Outperform Treasury Bills? The paper’s key findings could have implications for stock investors of all stripes. So, we were excited to talk to Hank and dig into his work. You can find this paper and other follow-on work that Hank has done on SSRN, and we’ll link to it in the show notes.
Hank, welcome to The Long View.
Dr. Hendrik Bessembinder: Well, thank you very much, Jeff. It’s a pleasure to be here.
Ptak: We’re so pleased to have you. I wanted to start by discussing why you wrote the paper, Do Stocks Outperform Treasury Bills in the first place? What led you to interrogate that question?
Bessembinder: Well, the truth is it was a bit of an accident. It was not the situation that I woke up one morning with that title question in my mind. So, in some sense, I stumbled into this line of research projects. I was working with a couple of co-authors on another paper, had a fairly broad sample of stocks. And for some techy reasons, we were working in that paper with continuously compounded returns or logarithmic returns, people sometimes call them. I just happened to notice that for this pretty big sample of stocks, the average or mean continuously compounded return was a negative number.
I’m just not expecting to see that. I’m not expecting to see a negative average return for a pretty big sample of stock returns. Gets a little techy, but one fact I was carrying around in my head is that for a given stock, if it’s average logarithmic returns a negative number, then it lost money for its shareholders over time.
Anyway, that’s a little techy, but in any case, I’m just looking at the summary statistics for this other study. And the thought suddenly strikes me, wow, it looks like maybe a lot of stocks are losing money over time. So, I thought I better start checking into that. So, I dug into it and that eventually led to the paper titled, Do Stocks Outperform Treasury Bills?
Benz: One of your key findings is that most stocks have failed to beat cash over their lifetimes. Can you elaborate on that and talk about what percentage of stocks failed to do so?
Bessembinder: So, the original paper had data from 1926 through 2016. I’ve done some updates to that since, but the punchline doesn’t change. So, I’ll focus on numbers from the original paper.
What I found is that when you compounded the returns for stocks over the full time that they were included in the database, that only about 43%, roughly three out of seven of the stocks, turned in better performance than Treasury bills over the same months, the same period of time that the stock was listed and included in the database. So, around the flip side, about 57% or, four out of seven, failed to beat Treasuries.
Ptak: So, just to clarify, you examined all stocks in the CRSP database dating back to 1926. I think that you said in the paper there were more than 25,000, give or take, stocks. So, the 43% that beat cash, that would equate to almost 11,000 stocks, right? And the 4% that account for all the wealth creation, which I think is another thing that we’ll get to, those would amount to nearly 1,100 stocks. Does that sound about right to you?
Bessembinder: Yeah. That’s about right. Rounding a little bit those numbers are on target.
Benz: So, this seems very counterintuitive. And maybe you can talk about how one reconciles your studies’ findings with the fact that the average stock return has exceeded the average return on cash or bonds over time.
Bessembinder: Yeah. I agree. It is counterintuitive, at least at first. What’s going on here from a statistical viewpoint is there’s positive skewness in compound returns. And a little bit of a techy term, but the essence of a positively skewed distribution is that most of the individual outcomes are lower than the average outcome. If you prefer, the median outcome is less than the average outcome.
But the only way that can be true, that most outcomes are less than the average is that you’ve got a few, relative few, outcomes that are much bigger than the average. So, in some sense, this paper and the follow-up papers I’ve done are really about skewness in compound returns. I’ll freely admit I chose the title for the paper, Do Stocks Outperform Treasury Bills?
I chose that title somewhat strategically thinking basically when anybody sees that title, they have to look at the paper and find out what is this crazy guy talking about. If they have a look at the paper, they’ll quickly see that I’m talking about individual stocks, not the overall market. I might have titled the paper Their Skewness in Long-Term Returns. And maybe eventually the message would have gotten out, but I think that would have been a less effective way of drawing people’s attention to the findings in the paper. But in essence, that’s the punchline of the paper, and it’s what drives what’s in the related papers is that there’s this positive skewness in the distribution of compound returns.
Benz: If we were to put your studies’ findings into present-day terms, does it seem reasonable to expect that less than half of the 3,700 or so stocks that are in Vanguard Total Stock Market Fund recently will beat cash over their lifetimes and around 150 will account for the value that the fund manages to create?
Bessembinder: Well, I’d be hesitant to make forecasts that are that specific. I do feel very confident having thought about it for several years now, having examined additional databases like international equities. I do feel really confident saying that I expect there’ll be the same sort of positive skewness in the distribution of returns in the future, with the central feature being that most of the individual outcomes will be less than the average outcome. But the degree of skewness can vary over time. We can talk a little bit more about what determines how much skewness there is, but the degree of skewness can vary. Then, of course, there’s the big question of what will the overall stock market do in upcoming months or upcoming years. So, I wouldn’t want to put specific numbers on it, but I feel confident saying that there will be this positive skewness.
Ptak: So, we wanted to turn and talk next about the attributes of the stocks that comprise your study. Maybe starting with the glass half-empty part, the stocks that either went under or failed to be cash, underperformed in essence. And then we’ll turn our attention to, I think, what you’ve referred to at times as home run stocks. But let’s start with the losers or the laggards. What explains why so many stocks failed to outearn cash? They can’t have all gone out of business, can they?
Bessembinder: Well, a good many did go out of business. Out of the almost 26,000 stocks in the original study, only a little over 4,000 were still in the database, still listed as of the end of 2016. So, the substantial majority of the stocks did disappear, did get delisted. There’s a variety of reasons that stocks can delist, but over 9,000 of these stocks were delisted by the exchanges for negative performance reasons, for income-related reasons, for violating minimum share price requirements. Matter of fact, when I looked at the distribution of compound returns, the most frequent outcome—modal outcome, if you prefer the statistical term—the most frequent outcome was a negative 100% return. So, the fact is there are a lot of stocks that go belly up. I should mention, though, that a good many stocks also delist for less negative reasons, for example, because they’ve been acquired or were in a merger. But between the negative reason delistings and those that delist because of mergers or takeovers, the majority of stocks actually don’t remain in the database. Going a little bit from memory here, but I think the average time that a stock was listed in the database was only in the vicinity of eight to nine years or so.
Ptak: Before I get to my next question, in those cases where firms are acquired assuming that there’s some sort of control premium that they’re able to get from the acquisition, that would be impounded into whatever return stream that you would have captured and included in the study. Is that correct? So, effectively they would get credit for that control premium?
Bessembinder: Yes, that’s correct. So, I think we mentioned that I used the database that we refer to by the acronym CRSP, Center for Research in Security Prices. I don’t think anybody can vouch for perfection, but I will say that all indications are that the people at CRSP have tried to be very careful in putting together a database that captures everything we would want to have captured.
So, among other things, CRSP includes what they label a delisting return. So, if a stock is removed from listing for whatever reason, they seek out information on the final payments or value of shares in some cases. They seek out information on the value of any final distribution to investors.
Ptak: Is it possible that some of these firms that underperformed or that failed altogether, that perhaps they delivered higher returns to investors before they went public?
Bessembinder: Yes. You bring up a good point. By studying the CRSP database, I’m studying the history of publicly listed companies. So, from the date of their IPO or spinoff onward, and of course, many companies had a history prior to their IPO. And in particular, the ones that do reach IPO stage, probably almost without exception, the large majority of those will have created wealth and positive returns for their shareholders prior to the IPO date. And that’s not captured in the study.
But I think as long as we’re taking the conversation toward private and pre-IPO investments, I haven’t done the research there myself, but others have. And all indications are that this phenomenon of positive skewness is even stronger pre-IPO. Venture capital, investments are notorious for having very positively skewed outcomes. In other words, most of your investments don’t make money. The most common outcome is lose all your money. But there’s a relative few really big winners that make venture capital worthwhile.
It’s those relatively few big winners that go on than any of them, to do IPOs and become part of the database. One observation I’ve made is that one takeaway or one interpretation of my study is that the public markets really maybe have more in common with venture capital than we may have realized, in that you find this positively skewed distribution in both the venture capital and in the public markets.
Benz: Seems likely that a lot of the stocks that failed to outearn cash were smaller micro-caps. Did your findings change at all when you controlled for size?
Bessembinder: Yes. And if you don’t mind, I’ll back up just a little bit and talk about what we’ve now come to understand about what’s driving this skewness in stock returns. As I said, ultimately my paper and the follow-on papers are about this positive skewness in stock returns. So, I showed it with some simulations in the original study and there’s a couple of Swedish economists, Adam Farago and Erik Hjalmarsson. Apologies to Erik if I didn’t get your name quite right there. They published a paper last year that goes deeply into the mathematics and verifies rigorously what’s going on.
Skewness is induced by compounding, and the longer we compound, the more skewness we get. And the higher the volatility of the short-run returns, say the monthly returns, the more skewness we get in the long-run returns. So, that insight, the skewness comes from compounding, and the more volatile the returns are, the more skewness you get underlies and provides perspective on your question about market cap. Large market-cap stocks tend to be less volatile than small market-cap stocks.
So, when I did—and I did—look at outcomes based on market cap, among larger market-cap stocks, there is skewness but considerably less skewness. So, what I did is in the original study, I looked at the decade horizon, not the full lifetime for the stock. So, I looked at things at the decade horizon and then I said, “OK, how large was the stock by market cap at the beginning of the decade?” And then I did the computations for the following decade.
And what I found is, for the largest decile of stocks, the majority did beat Treasury bills. Matter of fact, a little over 70% did beat Treasury bills over the following decade. So, the phenomenon of skewed returns is definitely strongest for small stocks. It’s still there for large stocks but much less pronounced.
The reason I can say it’s still there for large stocks is that, while the majority of large stocks did beat Treasury bills, the majority of them did not beat the overall market. And of course, the overall market is the average of all stocks. So, the skewness is still apparent even in the larger capitalization stocks just not as strongly.
Ptak: Is there any evidence that what you might think of as the increasing professionalization of investing has maybe rung out some of the excesses that formerly allowed borderline or flimsy firms to go public and then they would—predictably—they would flounder as public firms? And if so, do you think that that could imply the return distribution will be less skewed in the future because you’ll have fewer of these kind of borderline firms that are making it through an IPO into the public markets?
Bessembinder: That’s a good question. I don’t have a precise answer for you, but let me start by saying possibly. Your question is related to a couple of issues. One, we know there’s evidence that stocks that have done IPOs, or if we look at stocks in the months after their IPOs, that you tend to see on average underperformance. Loughran and Ritter, among others have documented that for some time.
On the other hand, it’s the case that small stocks, in general, have actually earned higher average returns than large stocks, at least in the long run, as we know that can change for a decade or two here and there, but in the long run, small stocks have done well. So, ultimately, I’m not sure if my evidence should be interpreted as saying that listing standards were too lax in the ’80s and ’90s, but perhaps that’s one potential interpretation.
In any case, if the world has changed so that the companies that do get newly listed are less volatile, have less-volatile returns, perhaps are larger at the times of their listing, then I would expect that that would translate into moderated, less skewness in long-term returns going forward.
Benz: That’s a look at the losing side of the ledger. Let’s talk about the opposite, the firms that were responsible for generating the lion’s share of the market returns. Are there any attributes that they shared in common such as above-average earnings growth? Any other factors that you could point to as commonalities?
Bessembinder: Yes. As a matter of fact, I should clarify, though, that it’s very difficult to predict ahead of time which stocks are going to end up in the right tail, which stocks are going to end up being the big winners. We know there’s been a long debate about market efficiency, that probably hasn’t been resolved yet. But it is competitive out there. So, if there was any easy way to identify ahead of time which stocks are going to be the big winners, well, there’s just a lot of competition to try to do that.
Benz: Yes.
Bessembinder: But that said, we can still look at the characteristics of the stocks that actually delivered the very high returns. I dug into that, and perhaps to a surprising extent, it looks like it’s fundamental factors that explain the really high performance by the stocks that deliver it.
Roughly speaking, these are growth stocks, but I don’t use that term in the way that it’s often used. For example, with the idea of that if you have a high market/book ratio, high market/book equity ratio, you’re a growth stock and vice versa. That’s not how I’m using the term. As a matter of fact, my evidence suggests that market/book ratios don’t forecast which stocks are going to end up being the really high performers.
So, when I say that they’re growth stocks, I mean that they deliver high fundamental growth. These are stocks with high asset growth, high sales growth, high cash growth, and most important of all, high net income growth.
Ptak: Maybe building on that, did the home run stocks, did their returns come in bunches over shorter intervals? Or was it more gradual over an extended period? I guess a somewhat related question that your previous answer had me mulling was, in order to obtain all of this value creation from these home run stocks over a holding horizon, is it necessary that investor begin with them as small caps? Or did you find in your study that a substantial amount of the value creation perhaps happened after they had graduated to mid or even large cap?
Bessembinder: To answer the first question, it tends to be gradual, in the sense that it’s not a huge run up in a month or two. Of course, that happens occasionally, but when you look at things systematically, the stocks that do end up delivering very nice long-term growth, what I looked at specifically was stocks that hit multiples like 25x relative to a previous point or 125x relative to a previous point. For the stocks that eventually get there, it is a reasonably smooth run up, on average, not an overnight phenomenon.
I think the evidence is that at least in a good number of cases, very substantial performance comes even for stocks that have substantial market capitalization already. A couple of examples that come to mind: Apple was actually listed for decades before it really took off as an investment. Roughly speaking, Apple really took off as an investment around the time of the introduction to the iPhone. I don’t remember the exact year, but somewhere around 2006, 2007. I’m sure readers can verify that.
Microsoft is another. Microsoft had very nice performance for a couple of decades, but then it languished for a good dozen or so years before it again turned into a top performer over the last most recent dozen or so years. So, there’s certainly cases where stocks that are already of substantial capitalization then turned into big winners for the subsequent 10 or 12 or 15 years.
Benz: I wanted to ask about the role of dividends. Studies have found that a big chunk of the market’s long-term return comes from dividends. Was that true of the home run stocks? Or was it more of a long-term earnings growth multiple expansion story?
Bessembinder: Well, I think the notion of growth in the way I’ve described it—growth in assets, growth in revenues, growth in net income—is the most important thing. But I did find that on average, the stocks that turned in the best returns did have both higher dividend yields and higher dividend growth than other stocks. You’re going to find plenty of exceptions to that, though. You’re going to find plenty of cases of stocks that are not paying dividends that are nevertheless among the top performers.
Ptak: We want to get to risk and return because I think that’s an interesting thing to reconcile with some of your findings. Before we did that, I wanted to talk about stock-picking. You ran a test in the paper in which you simulated choosing one stock a month at random to see how it would have fared versus the cap-weighted market, as well as cash. I think it’s a dart-throwing contest. What did you find when you conducted that experiment?
Bessembinder: First, let me preface why I decided to do that. I think I mentioned earlier that most stocks, although the original study had 90 years of data, most stocks are not in the database, not listed for anywhere near 90 years.
So, the first finding that we already discussed that about five out of eight stocks fail to beat Treasury bills was striking, but on average, that was over relatively short lives. So, the question that I had in mind was to say, well, what if we just thought about single-stock investing over the whole 90 years. Most stocks are not there for the whole 90 years. Those that are there for the whole 90 years, there’s a big bias in the sense, survivorship bias that these are the stocks that things went well for in a sense. So, I decided to use a simulation, as you said, where each month I would pick a stock at random. And then I would do that for every month and then compound the returns. So, that way I could get a 90-year return to a single-stock strategy that had a different single stock every month. Then, I could repeat that a lot of times and say, well, how would the single-stock strategies have turned out across lots of potential different choices of stocks?
What I actually found was that the phenomenon was even stronger once you looked at the single-stock strategies over the whole 90 years. So, at the 90-year horizon, the single-stock strategy beat Treasury bills only about one time in four, only about 25%. And the single-stock strategy beat the overall market only about 4% of the time.
Benz: It seems like the study is kind of a Rorschach test. Some people think it underscores the futility of active investing. Others have drawn the opposite conclusion, and they’ve used your findings to poke holes in the argument for indexing. So, where do you come down on that?
Bessembinder: Well, this may sound a little wishy-washy, but I come down on both sides of that argument. I think that my study provides new ammunition for both sides of the argument. One way of summarizing it is that for those people who were already inclined to think that the best strategy is diversify, buy and hold, my study gives them some new ammunition in support of that. On the other hand, for those people who think that they should be active investors, my study gives them some new ammunition. I’m not sure it has changed anybody’s mind. I’m not sure it’s moved anybody from one camp to the other, but it’s given people in each camp some additional reason to think that they’ve got the right position.
For the people who favor broadly diversified portfolios, the new information, everything that’s in the textbooks, everything you’ve already read about the benefits of diversification still holds. But on top of that, you’ve now got the point, if you just pick a few stocks at random, the odds are against you. It’s more than 50-50 that you’ll underperform the market if you just pick a few stocks at random. That’s the nature of skewness. Most of the stocks are going to underperform the average, and the market’s going to deliver the average. So, that’s some additional ammunition for the people on the diversify side.
For people on the other side, first of all, there’s what economists call skewness preference. That is a preference for the possibility of a big-winner outcome. Having skewness preference is not irrational. Economists can’t say that’s an irrational way to think about the world. Diversifying reduces risk as measured by something like standard deviation. Diversification also reduces skewness. So, if skewness is what you want, if the possibility of a really big outcome is what you want, my study shows that you’d prefer to be less diversified.
And then on top of that, I’m trained as an economist, and I think that what economists call comparative advantage or in layman terms, what are you good at, what are you better at than your competitors. I think it’s a really important proposition. I think it’s a really important way, really useful way of thinking about the world. Some people have comparative advantage in identifying misvalued stocks.
It may not be a lot of people. An analogy I’ve drawn before is the percentage of the population that has the comparative advantage to identify misvalued stocks might not be any higher than the percentage that has the comparative advantage to play professional basketball. But some people have the comparative advantage. For those that do have the comparative advantage, if you’re thinking of the world as symmetric, you might underperform the average, you might outperform the average. Well, that’s one worldview.
The data that I’ve shown is that that’s not the accurate worldview. There’s the possibility that if you’re not diversified, you’ll outperform the market by 5x, 10x, and so on. So, for those who fancy themselves as having the comparative advantage or believe they can find an asset manager with the right comparative advantage, my study underscores the potential upside to active strategies.
The only additional thing I’ll throw in there is that we’re all human. There’s a lot of evidence from the psychology literature that we humans are overconfident, on average. So, as we think about the question of whether we have the comparative advantage that’s necessary, or that we can find an asset manager that has the comparative advantage, we should think about bringing some humility to bear. Think about the danger that we’re just being overconfident.
Ptak: Before we talk about risk and return, I wanted to ask you if you think the daily liquidity open-end mutual fund and the regulations that govern those vehicles, whether that’s well-suited to successful stock-picking for say those investors that do have that comparative advantage that you talked about? Or is something like a hedge fund or a closed-end fund, which lock up capital, is that more conducive given the need for patients and high levels of concentration as your study seems to imply are required?
Bessembinder: So, a very good question. I will say my study is fundamentally about long-run outcomes. I don’t really have anything new to say about short-run outcomes in the market. The skewness that I’ve documented is a long-run outcome.
If these studies have altered how you think about investing, it should be along the lines of having a more concentrated portfolio, which would have more skewness, and then allowing the power of time in the market to work.
These would be long-run strategies. And that requires patience. On top of patience, it requires the ability to live through some drawdowns. I have one of my follow-on papers that looks at the likelihood of drawdowns, and even the most successful stocks had substantial drawdowns. Stocks like Apple and Amazon had drawdowns of 70%, 80% around the time that the dot-com bubble burst.
So, even if you have the comparative advantage, it requires a long-run worldview and it requires the ability to live through short-term turbulence. And it’s an open question whether the typical open-ended investment fund can attract investors that have the necessary long-term view and the ability to live through intermediate drawdowns. So, it may well be that funds that can lock up money for a time would have a comparative advantage, would have an advantage in trying to pursue these strategies.
Benz: In the paper, you take some time to explain that your findings don’t necessarily call the relationship between stock returns and risk aversion into question. Can you walk through that?
Bessembinder: It’s going to be a little techy because it’s an economic equilibrium sort of question, the sort of thing that finance theorists think about. But it is a central tenet of finance theory, and I think most people’s worldview, there should be a positive relation between risk and expected return.
The thing about that phrase—expected return—that refers to the mean outcome across possible future outcomes. So, we don’t know what the future will bring. There’s a variety of possibilities. But when we average across all those possibilities, that’s what we have in mind when we say the expectation. So, the expected return should be higher for stocks with more risk.
The thing to recognize is that for any given stock, you only get to see one path. You only get to see one outcome over the decades, and there could have been other outcomes. So, the theory talks about the average across all those possible paths. The data shows that when we average across stocks, which we can think of as averaging across the possible paths for individual stocks, we do see positive average returns for this risky asset class that we call the stock market.
What my study has added to the discussion is that most of the individual paths, most of the individual possible paths, and most of the individual paths that actual stocks follow are money losing. But there’s a relative few that do really, really well. And when you bring it all together, on average, across the stocks, across the possible paths, we’ve still got the central point from theory that the expected or average return is higher in this risky asset class as compared with Treasury bills. Hope that made sense.
Benz: It did. Thank you.
Ptak: I wanted to follow up. There’s a related point, and you touch on this in the paper—investors, they often equate volatility with risk. Standard deviation assumes returns are normally distributed, but you found that the distribution of stock returns is anything but normal. So, do your findings call popular measures of risk measurement and management into question, too?
Bessembinder: I actually think that that is the case, that we should at least be giving additional thought to some of the ways that we measure stock market outcomes. In my view, much of how we talk about stock market outcomes is rooted in the capital asset pricing model. For anybody listening who’s been to business school, you will have been introduced to the capital asset pricing model. Even if you haven’t, you’ll be indirectly affected because it seems to shape how we think about measuring investment outcomes.
So, for example, alpha as a measure of stock performance or a measure of performance for mutual funds or other money managers. Not everybody recognizes that this was originally called Jensen’s alpha, named after Michael Jensen, who unfortunately just passed away a month or two ago. But if you go back to Jensen’s original paper, he’s very explicit when he developed this idea of alpha as a way to measure stock performance. He’s very explicit that he was focusing on the capital asset pricing model, and that was the basis for it.
As you pointed out, the capital asset pricing model is based on an assumption that stock returns are normally distributed. We’ve actually known for a long time that stock returns are not normally distributed, and this was known back when the capital asset pricing model was developed in the ’70s. But the discussion at the time was focused on what statisticians call fat tails. In other words, there’s more really big returns and more really low returns than there would be if stock returns were normal.
But the general thinking was, well, close enough. Yes, we know that stock returns are not normally distributed, but close enough. And if you’re in, say, weekly returns or monthly returns, you can tell that story. Well, it’s not exactly normal, but close enough.
One reason that my work was surprising to a lot of people is we’ve been so focused on studying outcomes for returns measured over short horizons, like monthly returns or maybe annual returns. Where the skewness really shows up is when you compound returns over longer periods, like say a decade, a decade or longer. The skewness becomes really strong. A normal distribution doesn’t have any skewness.
So, the evidence is really strong that if we look at longer horizons, stock returns are not normal. So, many of our measures that are rooted in the capital asset pricing model and rooted in the idea of normal returns, which includes things like alpha, it includes mean-variance optimization, it includes Sharpe ratios. I think we should give more thought to whether these are really the best and most informative measures for investors. When you take into account that long-term investors, the returns are anything but normal.
Benz: We wanted to discuss the implications for portfolio construction. It’s hard to predict which stocks will be the big winners. And so that could argue in favor of widely diversifying a portfolio. But do you think it’s also an indirect argument against rebalancing an equal-weighting portfolio?
Bessembinder: I’m not sure if it’s an argument for or against. I think it’s evidence that informs the discussion of the merits of rebalancing or equal-weighting. One thing to recognize about either equal-weighting or rebalancing is that they are active strategies. They’re not passive by an old strategies. If you start out equal-weighted, if you want to get back to equal-weighted, you have to rebalance. You have to sell your winners and buy your losers to get back to equal-weights. Equal-weighting and rebalancing are fundamentally intertwined in that sense.
But one of the issues to think about is, do we think that stock market returns display momentum, or do we think that they display reversion? Rebalancing strategies are basically contrarian strategies. So, if the returns are reverting, you’re going to improve your average return by rebalancing and vice versa. If there’s momentum, you’re going to reduce your average returns by rebalancing.
So, as I said, I don’t think I have an answer. I just have some additional things to think about. The desirability of rebalancing is intimately tied up with whether you think stock returns tend to continue or tend to reverse.
Opposite side of that argument, for those that don’t want to rebalance, just recognize that if you’re buy and hold, as more time goes by, you’re going to become less diversified. Your big winners are going to become a bigger part of your portfolio if you don’t rebalance. We see that in the S&P 500 with all the talk about the “Magnificent Seven,” which is basically that the big winners now have very big weights, and it raises the question of whether the S&P 500 is still as diversified as it might be, given how well some of the stocks have done. So, it’s really a matter of the trade-offs and really just trying to get a better understanding of what the trade-offs are.
Ptak: I want to talk about macro for a minute. Do you think your findings have implications for the way firms are brought to market? Does it suggest that the IPO process doesn’t support efficient price discovery, for instance?
Bessembinder: I can understand where the question comes from, because we do have the evidence from Loughran and Ritter and others of average underperformance in the wake of IPOs, which is maybe suggestive that the prices were too high at the time of the IPOs. But at the same time, small stocks as a class have done well. So, I think that’s the tension.
If it is the case that in the past, IPOs have been overpriced on average, then better pricing mechanisms could potentially reduce the failure rate or reduce the underperformance rate. But as you know, and I’m sure many people who are listening know, there’s been a lot of debate about the IPO process and a lot of discussion about whether the IPO process can be improved. Our current system seems to be surprisingly resilient. We’ve had occasional direct listings, we’ve had occasional Dutch auctions, we had the surge in SPACs as a way of going public in the last few years. But none of those seem to have stuck around. So, our existing system of IPOs are operating through investment banks with book building and such. It seems to be a really resilient system. When something’s really resilient, there may be economic efficiency arguments for it.
Benz: I wanted to do ask about the implications for stock-based compensation, which is a tool that many publicly traded companies use to attract and retain personnel. It’s only natural that a firm’s leaders would be optimistic about their stock’s prospects. But given how few stocks live and outperform cash, do you think that employees should be learier about that form of compensation?
Bessembinder: Short version, yes. I think stock-based compensation makes sense for some really good reasons that are not undone by my study. They’re excellent for aligning incentives of employees with shareholders. For early stage firms that may not have a lot of excess cash, there are a way of providing valuable compensation, even if cash is in short supply. So, those are strong arguments. Those are important. But my studies show that, in fact, most individual stocks end up performing poorly.
So, it’s always possible that you’ll be getting shares in the next Microsoft or getting stock options in the next Microsoft. But it’s more likely that you’ll be getting shares in a company that 20 years from now will be somewhere in the database and people don’t remember the name. So, just has to be realistic that the odds are against any given randomly selected company doing well in the long run.
Ptak: I’m conscious of the fact that we’ve spent most of our time talking about your findings pertaining to the US market. But I think you’ve done some work looking at applying the same study to stocks outside the US. What did you find when you did so?
Bessembinder: When I originally circulated the first paper, it struck me that there were two burning questions. One is, is it possible to predict which stocks are going to end up in the right tail? So, I did some work on that, and perhaps not surprisingly the answer is it’s hard to predict who’s going to be there, especially with any publicly available information like accounting information or return histories.
The second really obvious question was, OK, so there’s this striking finding for US stocks, but is it universal? So, together with some co-authors who had good access to the global data, we did a parallel study for the international markets. It was quite broad. I think we had over 40 countries. We had, I think, about 65,000 stocks in the study.
The punchline is what I documented for the US is not at all unique to the US. As a matter of fact, if anything, the general pattern that a majority of stocks underperformed Treasury bills and that a very small percentage of stocks are ultimately responsible for the value creation in the markets. If anything, those conclusions are a little bit stronger outside the US than they were in the US.
Benz: So, if I’m a buy-and-hold investor, what changes should I consider making to my approach in view of your findings? And then, on the flip side, if I’m a more frequent trader, what should I be doing differently in the future?
Bessembinder: The answer may surprise you a little bit in that, it may be that this doesn’t mean you should change anything. As a matter of fact, this might just mean you should continue doing what you’re doing and feel a little more confident in it. But some people should perhaps give some thought to making some changes. Perhaps beyond the really big question of does it make sense to be a passive diversified investor or does it make sense to be a more active, narrowly focused investor, beyond that question, I think it does call into question or give reason to think more about being a diversified buy-and-hold investor.
Because there is this skewness in the distribution and a diversified buy-and-hold portfolio, if you let it run, in particular if you let it run for a decade or two, it’s not going to be as diversified anymore. Some of the stocks will drop out, and more important, the big winners will start to become a larger percentage of your holdings. So, for the long-term investor, I don’t think there’s a prescription. You should rebalance more often, but you should give thought to whether you want to rebalance more often.
For short-horizon investors, I’m not sure there’s really anything new here. Some of my other papers have had findings that might be relevant for short-horizon investors, people who trade more frequently. For example, I have a paper about potentially trading around firm’s dividend announcements. But in terms of this paper and the follow-on paper, I don’t think it has anything new for the short-horizon investor. The findings in my paper are relevant for people who want to think about long-term investment strategies.
Ptak: Well, Hank, this has been a fascinating discussion. Thanks so much for sharing your insights with us. We’ve really enjoyed speaking with you.
Bessembinder: Well, it’s been my pleasure and I hope that the comments are useful to some people.
Benz: Definitely. Thank you so much, Hank.
Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts. You can follow me on social media @Christine_Benz on X.
Ptak: And @syouth1, which is S-Y-O-U-T-H and the number 1.
Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com . Until next time, thanks for joining us.
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