Look Down Before Looking Up - Part 2

This is a companion piece to "Look Down Before Looking Up - Part 1." In part 1, we explored that a significant proportion of stocks have negative lifetime returns. In Part 2, we review data about the winners.

1% IRR Takeaways:

• Since the inception of the S&P 500 in its current form, the index has compounded ~10.3% per year from 1957 to 2023.

• While the stock market goes up over the long term, stocks do not. From 1926 to 2023, ~52% of stocks listed in the US have negative lifetime returns.

• Data analysis reveals that a few businesses are responsible for driving stock indices higher.

• Whether you are a “look for the winner type” or an “avoid loser type” isn't important. However, understanding your archetype is. 

Defining Investment Success

Key Point: A “good investment” is one that generates returns surpassing an objective benchmark, not merely yielding a positive return.

The primary goal of investing is to enhance future purchasing power. Various investment vehicles exist to achieve this objective, ranging from low-risk treasuries to higher risk options like stocks, private investments, commodities, etc.

Investing in the U.S. economy has been a remarkable strategy over the past century. The S&P 500, a market-cap weighted index of the 500 largest U.S.-listed companies, serves as an excellent way to invest and gain exposure the U.S. economic spirit.

For investors venturing beyond index funds, the S&P 500 provides a crucial benchmark for measuring opportunity cost. Therefore, the index becomes an objective standard for comparison when analyzing the historical performance of individual stocks.

First Principles - Evaluating Historical Data of Individual Stocks

Looking Up

By analyzing the history of all U.S. stocks from 1926 to 2023 (Hendrik Besseminder, professor at Arizona State University, has done excellent research compiling and analyzing historical stock prices), certain patterns emerge.

Focusing only on the positive outcomes:

• ~48% of all stocks produced positive lifetime returns

• ~28% of all stocks achieved annualized returns exceeding 10%

• The percentage of outperforming stocks decreases when factoring in holding periods

Focusing on companies that have existed for more than 5 years (a proxy for long-term investments), the data tells a more challenging story. 

Data Story - Understanding Historical Stock Returns

Picking winning stocks has historically been a coin flip (Figure 1).

However, finding the companies that compound at above market rates for long-term periods offers odds more like rolling a die and betting only on 6.

The data underscores a crucial point: of all the 28,843 U.S. companies ever listed, fewer than 3,000 have provided annualized returns exceeding 15% over a 5+ year holding period.  Additionally, with so many negative-performing stocks, the indices are driven higher by a fraction of stocks.

Fork in the Road

Investors will have a natural predilection when considering investment decisions and typically fall into two categories:

(1) Those who seek winners

(2) Those who aim to avoid losers

Every person has a genotype (an organism’s genetic information), and phenotype (a set of observable traits). In a study published January 14, in Nature Genetics 2019, an international research team identified 124 genetic variants associated with a person’s willingness to take risks.

Key points: 

• There is no individual variant that meaningfully affects a particular person’s risk appetite.

• Non-genetic factors, i.e., life circumstances, matter more for risk tolerance than genetic factors.

While genetic factors play a role in risk tolerance, life experiences and circumstances weigh more significantly on our risk-taking behaviors.

Investor Archetypes

1.  The Entrepreneurial Optimist: Focuses on potential upsides and sees promise in various businesses.

2.  The Distrusting Pessimist: Views C-Suite executives with skepticism and is concerned about shareholder exploitation.

Both types of investors are right and wrong. It’s not important to be one or the other, the key is to recognize your inherent bias.

In a recent interview, Reed Hastings, co-founder and executive chairman of Netflix, made this confession – “If you mean financial investments, the few times I’ve done investing, I’ve lost my shirt and I realize I’m just so optimistic. I like anybody who seems to have a good idea, I’m like, “Sure.” So I think it’s a different DNA than investors have that are differentially good investors. So I’m a pure index fund investor. I’m Netflix plus index fund.”

Mr. Hastings comment exudes self-awareness. Not everyone has to take such an extreme approach, but guardrails around optimism are important.

1% IRR Improvements:

• Statistically, finding winning stocks is challenging. For any random stock, it’s more likely to lose money than beat an index.

• Know thyself: If you are an optimist, look down before you look up.

As Ben Graham once said: “The intelligent investor is a realist who sells to optimists and buys from pessimists.”