We Study Billionaires - The Investor’s Podcast Network - TIP667: Why Most Stocks Will Lose You Money w/ Professor Hendrik Bessembinder

Starting point is 00:00:00 You're listening to TIP. On today's episode, I'm joined by Professor Hendrick Bessimbinder. Hendrik is a finance professor at Arizona State University and his well-known research titled Do Stocks Outperforms Treasury Bills has been referenced many times on the show? He's also a frequent speaker at conferences in universities around the world. Hendricks' research on the stock market found that since 1926, just 4% of U.S. listed companies generated all of the net returns to shareholds.

Starting point is 00:00:30 holders. Statistics like this can certainly humble investors trying to pick the next big winner in the market, but it also shows just how powerful stock picking can be if you're able to find even one of these top performers. During this episode, Hendrik and I discuss why most stocks lose money in the long run, the level of asymmetry that exists in the stock market, why stocks continuously outperform treasury bills over long time periods, what's the average drawdown for a high-performing stock, the most common characteristics of the biggest stock market winners, what it takes to be a stock picker in today's market, how skewness differs for international stocks relative to U.S. stocks and so much more. With that, I bring you today's discussion with Professor Hendrick Bessonbinder. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-reliquist. made billionaires the most. We keep you informed and prepared for the unexpected. Now, for your

Starting point is 00:01:36 host, Clay Fink. Welcome to the Investors podcast. I'm your host, Clay Fink. And today I'm happy to welcome Hendrik Bessam Binder, Hendrik. Welcome to the podcast. Thanks, Clay. Happy to be here. So Hendrick, I must say your research is really making waves as your study titled, Do Stocks Outperform Treasury Bills? It's been a reference several times on our podcast, and it's been a study that I think in humble many stock pickers in the audience. So you first looked at the performance of individual stocks relative to treasury bills from 1926 through 2016. And I believe you updated that study through 2020 and 2022. So how about we just get this kicked off as what was the impetus for performing this study? Well, in all honesty, I kind of stumbled into this line of

Starting point is 00:02:33 research by accident. And the answer of how it happened is actually a little bit techy, but I was, you know, I'm basically a data guy, a statistics guy, a finance professor who studies the markets. And I was working on a project with a couple of co-authors, and we were studying stock price performance after events like IPOs and secondary offerings and the like. We had a pretty big sample of stocks. And for some technical reasons, we had decided in that study to look at a continuously compounded returns or logarithmic returns. And I was looking at our data, our summary statistics, for a pretty big sample of stocks, and I noticed that the average continuously compounded return for this pretty big sample of stocks was a negative number. I was surprised. I wasn't expecting

Starting point is 00:03:20 to see a negative average return for a big sample of stocks. And just another techy aspect here, I had in mind that one of the reasons people study logarithmic returns is that they add up nicely. So if an average is negative, then the sum of all of them is negative. And a logarithm is not actually a return. You have to convert it back. But you don't change the sign when you convert it back. But I'm just looking at this data, and it suddenly occurs to me, a lot of these stocks are losing money in the long run.

Starting point is 00:03:51 And I wasn't expecting that. So I thought, well, I should really start digging into this a little more systematically. So I did start digging in systematically, and that led to the paper you mentioned. I should mention, by the way, I titled that paper, Do Stocks Outperform Treasury Bills? I mean, that was basically a strategic title. My thinking is, if you use that title, people have to look. They have to see what's this guy talking about. But underlying the outcome, so that the outcome that's in, the outcomes in that paper, is skewness.

Starting point is 00:04:23 Now, that's another kind of techy term, and maybe you prefer asymmetry. But the fact is, stock market returns once we've, we've, compounded them for a while, are positively skewed. If you have positive skewness, it means the average outcome is higher than most of the individual outcomes. And that's essentially what's going on, essentially what drives this whole line of research. If I had labeled that original paper, stock returns are skewed. I just don't think it would have caught people's attention in the same way that the actual title did. Anyway, so it is really something that kind of stumbled into, but once I stumbled into it, I thought, well, these results are really striking. I should circulate them.

Starting point is 00:05:02 Went ahead and did that, and it's been interesting to see how much attention has been focused on it since then. One of your comments that stuck out to me at the start of your answer was that the average return for a stock is negative and that surprised you. For those that might not be math inclined, why did that finding surprise you? Well, there's a big economic body of theory and evidence of about risk-return trade-offs. And stocks are one of the more risky asset classes, maybe not the very riskiest. Maybe venture capital is more risky, maybe some exotic markets like, say, electricity derivatives might be more risky. But stocks are among the riskier assets. So we expect a positive average return in stocks. And I should clarify, it is true that the average return,

Starting point is 00:05:50 the mean, the same average you've been talking about since sixth grade or so, the mean return on stocks is positive. It's that return on a typical stock is not positive. So that's one of the striking things that came out in my original study. I used a database acronym as crisp. Center for Research and Security Prices is put together by the University of Chicago. It's what most academic study, and it's kind of considered the gold standard database for reliable historical stock return data. I studied the crisp data since 1926, all the individual stocks found that the majority of stocks lose money. I focused in the paper on comparing stocks to treasury bills, because I had kind of in mind the idea of a risk premium, we're supposed to earn a risk

Starting point is 00:06:35 premium in stocks as compared to something low risk like treasury bills. Anyway, what I found is that the majority of stocks, about four out of seven don't beat treasury bills in terms of their compound returns. If I focused on the number that I called shareholder wealth creation, which the biggest difference between that and a compound return is it just takes the size of the investment into account. So if we want to ask a question like, well, investors, the body of investors, the group of investors in the stock market, how have they done in the long run, how much wealthier have they become? With that sort of question, it's natural to think about things in dollar terms, which then puts more importance on big stocks. In any event, when I did look at

Starting point is 00:07:18 things in a dollar term, this wealth creation measure, it was even more striking. About 4% of the stocks accounted for all of the net wealth creation in the stock market since the U.S. stock market since 1926. So I was surprised because we usually think there's a positive risk return tradeoff. And I should mention it is there on average, but it's not there for the typical stock. How can it be there in the average, even while it's not there for most stocks? because there's a few stocks that do tremendously well that pull up the average. That's the essence of the findings. Yeah, and if I can paint some numbers from your research,

Starting point is 00:08:00 I believe one of the earlier studies that looked at 25,000 companies in aggregate, they created $35 trillion in net wealth creation. But if we tune in to those top top performers, the top 90 account for over half of that 30. $35 trillion. And it's the top 1092 that is the 4% figure you've referenced there that accounted for that in aggregate $35 trillion. So I think that top 90 really stands out to me.

Starting point is 00:08:29 So it's just like this tiny subset is driving so much of the performance of the broad overall market. So those were among the results that surprised me and I think surprised a lot of people. I should mention when I first came across these results, who was starting to talk to some my academic colleagues about it. Many people like me were surprised, but there was a handful of them said, well, of course, what did you expect? Which just shows that some people had already thought carefully through these issues, even if they hadn't stopped to actually document it previously. And you mentioned venture capital. People often think that a venture capitalist is going to go out.

Starting point is 00:09:06 They'll make a hundred investments, and they're very happy if one or two or three work out very well. And people sort of perceive that as a risky activity, venture capital in general, but they're doing the same thing when they buy a passive index fund. Just a select few is going to be driving those returns. So skewness is something that we see in many areas of investing, life, a lot of areas. And people talk a lot about power laws and it relates to that as well. Yes, I agreed. So I think skewness is pervasive.

Starting point is 00:09:37 One of the ways I've described the results of this study is I said, look, I'm going to tell you about an asset class. And in this asset class, most of the investments lose money. As a matter of fact, the single most common outcome is losing all your money. But there's a few really big winners. There's a few of these investments that really pay off handsomely enough to make this asset class worthwhile and desirable. And if I described it that way, a lot of people would respond, yeah, we know that about venture capital. But of course, I'm talking about publicly traded common stocks over longer horizons. So what I conclude from this is that this positive skewness, it's not something that just shows

Starting point is 00:10:20 up in some corners of the capital markets like venture capital. It's really pervasive. It's fundamental to investing in an entrepreneurial economy. So if you were to try and explain why this skewness exists to such a large degree that so few companies generate the majority of the wealth and the economy and the majority of the returns for investors, how would you try and explain why? that is. Well, there's a couple of ways to come at it. One of them is just kind of let's think about the details of what happens when you compound returns. The other is just kind of think about things

Starting point is 00:10:54 at a big picture, intuitive level. Let's take the first of those first. Just what happens when your compound returns. Real sinful numerical example. Suppose returns are either 10% for negative 10% Nice round numbers, nice symmetric, nice symmetry there. Suppose you get lucky and you draw 10% returns two times in a row. 10% compounded for two years is not 20%, it's 21%. On the other hand, you might get unlucky. You might draw negative 10% two times in a row, but negative 10% compounded for two years is not negative 20%.

Starting point is 00:11:28 It's not negative 21%. It's negative 19%. All right, simple example, but you can already see the asymmetry. Two good draws in a row, you're up 21%, two bad draws in a row, you're down 19%. That's essentially it. You can have complete symmetry in what happens in the short run, but once you compound things out, you get asymmetry. The longer you let that run, the bigger the asymmetries get.

Starting point is 00:11:54 The degree to which the upside is bigger than the downside. So it comes right out of the mechanics of compounding. But if we backed away from that example, just thought about things kind of intuitively, and what do we actually see in the markets? Well, what's the worst you can do on a stock? Negative 100%. Okay, that's mad. And it does happen surprisingly often. That was one of the things that came out of my study. But you're capped on the downside at negative 100%. It's because of limited liability, but you're not capped on the upside. And many, many stocks do more than 100%. And as I've shown in the series of studies, but not totally a surprise, many people have taken note of this in the past.

Starting point is 00:12:33 On the upside, a stock can generate thousands of percent, tens of thousands of percent, or in a few cases, a million percent. So the limited liability, unlimited upside is just another way of seeing that things are asymmetric in the long run in the investment world. So another interesting finding, I think, is looking at the performance of stocks overall relative to treasuries. And consistently, this is just a pretty wide margin between the performance of these two. asset classes, why do you think there's this almost continuous performance of stocks over an asset class like treasuries? To go back to kind of basic economics, we believe people are risk-averse. They need to be induced or compensated to get them to take risky investments. At least that's kind of a pillar of economic theory. There, it is interesting that you can find counter-examples

Starting point is 00:13:26 out there in the world. I mean, Las Vegas and casinos in general provide a counter-example. You know, there may be a couple of games of chance where you can tip the odds in your favor, but you know, they're likely to show you the door if they find your card counting. But those are some counter examples that are worse for thinking about. But in any event, from an economic theory perspective, we believe that there should be inducement to get people into this risky asset class stocks when you could be in low risk alternatives. From an academic perspective in terms of what's been written in the economics literature, there's a phrase equity premium puzzle. and that phrase is basically it's surprising how well stocks do, how big the premium is for the overall

Starting point is 00:14:07 stock market. It depends on exactly how you measure it in exactly what period of time, of course, but numbers like 8% per year are thrown around as the equity premium, and by some measures, that's a surprisingly large outcome. I might mention, though, I think you use some phrasing along the lines of, you know, reliable premium or most of the time premium or something like that. There is ongoing debate about how sure can we be that stocks will outperform low-risk alternatives in the long run. And there was a recent paper in the Financial Analyst Journal by a fellow named Dech McQuary. I believe he brought out some additional historical data and says the odds that overall stock market might underperform over, say, a 20-year horizon, are a little higher than that than what some

Starting point is 00:14:51 people have argued. The historical data shows the overall stock market has outperformed And treasuries buy varied, had some margins in the long run, which I think only makes it a little more striking that so many individual stocks don't do so. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year,

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Starting point is 00:18:56 sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. So one might look at a study like yours and simply say that they're just going to go out and try and by the winners, but if only the stock market, we're so easy. The biggest winners also tend to have gut-wrenching drawdowns, just to pull one example from one of your studies, you found that Apple.

Starting point is 00:19:34 It created more shareholder wealth out of any company from 1981 through 2019, but it also experienced three drawdowns of 70% or more. Talk more about some of your findings from this study on drawdowns and what might be a normal drawdown for a high-performing company. Yeah, I mean, there's no way to say with any degree of certainty what's going to happen in the future, but have studied pretty big databases of what's happened in the past, and that's something we should pay attention to. So in the study you just alluded to, what I did is I looked at things at the decade horizon, and I basically asked, let's focus on the stocks that turned out to be big winners in a given decade. I focused on the top 100

Starting point is 00:20:18 stocks in terms of enhancing shareholder wealth by a decade. And then I just asked, well, what sort of drawdowns did we see? These are stocks that turned out doing really well. How did they do? You mentioned Apple as a striking example of a stock that had some gut-wrenching drawdowns, Amazon, not three times, but they have a 90% drawdown. In any event, what I found is in the study of things at a decade, even within the same decade where these stocks turned out to be big winners, they had drawdowns that averaged 33%. And in the prior decade, the decade before they went on to become big winners, they had drawdowns that averaged 52%.

Starting point is 00:20:56 So I know among your viewers, there's quite a few people who try to engage in stock selection, just recognize that drawdowns happen frequent. Even for the big winners, it's not unusual to see big drawdowns, so just take into account that that's part of the game. And when looking at the industry breakdown, Many of these top performers are often technology companies, especially nowadays. And that can just make things even more complex for stock pickers. These types of companies seem to be more difficult to understand, faster changing industries,

Starting point is 00:21:29 a lot of potential for disruption that is almost impossible to foresee for many people. And for every tech winner, there tends to be a long list of companies we've never heard of that produced deeply negative returns. to what extent do technology companies dominate this list of top performers? Yeah, it's a good question. When you look at one of the lists I created of the top performers in dollar terms, there's a lot of tech companies on that list. But as you said, nobody forgets Apple, nobody forgets Microsoft, nobody forgets

Starting point is 00:22:02 invidia. What's easier to forget is the dozens of tech stocks that were around for a while and it failed. So when I'd done deeper into it, I actually found that technology, stocks were not more likely to end up at the top. As a matter of fact, to a slight extent, tech stocks were more likely to end up among the modern performers than to end up among the top performers. And I actually found that a couple of other industries, in particular healthcare and pharmaceuticals, as well as energy firms, somewhat more likely to end up in the top performing list as compared to their percentage of all the stocks. This wasn't a night and day thing. It's not

Starting point is 00:22:39 like any industry is going to reliably provide the stocks that end up at the top performing list. But tech stocks were not the most likely, and by a small margin, health and pharmaceutical stocks, and energy stocks were actually more likely than end up near the top of the list. And the most popular study looked at the performance of individual stocks relative to treasury bills, and we find that around 4% of stocks generate all of the net wealth creation. and I believe just under half, around 42% outperformed one-month treasuries. Have you looked at any data that instead of comparing to the performance of treasuries, you're looking at some sort of market index like, say, the Dow Jones Industrial Average or S&P 500?

Starting point is 00:23:24 I've never actually compared to those widely recognized indices. And that's in part because the indices themselves have their peculiarities. You're probably familiar that the Dow is something of an odd creature, a price weighted index. The S&P 500 is more straightforward in being a value-weighted index of the biggest stocks, but there's still some discretion in terms of which stocks get included in that index of which you don't. It's not purely the highest market capitalization stocks. So I went with something just a little more agnostic, is that I just computed a value-weighted portfolio of all the stocks listed on the markets,

Starting point is 00:24:03 all the stocks included in the crisp database. So it's not an index. It's just a valuated portfolio of all the stocks. I did several of my studies I also compared to the evaluated portfolio. The effects of skewness are still evident there. The majority of stocks underperform the evaluated portfolio. If it was a purely symmetric distribution, the average stock would match the average return. But even there you see at most stocks underperforms their own evaluated average. Just another way Qness presents itself. I know this might be the million dollar question a lot of listeners are waiting for. What are some of the characteristics that might help us select, say, a big winner? What are some of the things that are attributed or what characteristics are found in some of these big winners?

Starting point is 00:24:51 Yeah, so this is what everybody wants to know. And of course, they don't want to know just what are the characteristics that you can observe after the fact. They want to know what predicts. And we don't have to turn this into a long treaty on market efficiency. The markets are not perfectly efficient. There's a lot of debate about, you know, well, are they close? Are they not close? And, you know, I don't have any final answer to that question. Just there's a big ongoing debate about how efficient the markets are. I don't know if they're efficient, but what I do know is it's competitive out there. There's a lot of smart people looking for the answer to the question you posed. So nothing's going to be easy. If I had told you, I did a study and I found this variable that you could find,

Starting point is 00:25:32 on the firm's accounting statements, and it reliably predicts who's going to be the big winner next year. If that's what I was saying, you know, you should be highly suspicious of that. So, anyway, that's not what I'm going to say. It's devilishly hard to predict who's going to be a big winner. But when we look at who is a big winner, we can look and see, do they have something in common? And I don't know if this is surprising or not. I guess it depends on your perspective. But who ends up being a big winner is a remarkably fundamental thing. Their growth, stocks, but not in the way that everybody uses the term growth stocks. So a lot of people use the word growth stock to mean a stock that has a high market value compared to the book value of its equity

Starting point is 00:26:14 or the book value of its assets or something like that. With the reasoning for that terminology being the only reason it has that high market value is that investors are expecting rapid growth. Anyway, that's not how I'm using the phrase growth stock. What I mean is it's stocks that actually grow their fundamentals. So when I looked systematically at the data, and again, this was done at the decade horizon and said, okay, for the stocks that ended up being big winners in a decade, what can we say about them? Well, on average, they grew their fundamentals. They grew their assets. They grew their cash balance. Although my guess is that the causation is going the other direction there. The cash village grew because things were growing so well. Their assets grew, their cash balance grew.

Starting point is 00:26:57 they were unusually profitable, just in terms of income-to-asset ratio. And I ran some statistical horse races. Most important, net income growth, the proverbial bottom line, companies that have rapidly growing net income tend to do really well. I don't think that makes it any easier because predicting which firms are going to have rapid income growth is not an easy thing either. But I do think it helps to focus your thinking. If you can identify stocks that are likely to have rapid income growth, you've

Starting point is 00:27:27 identified stocks that have a better than average chance ending up on that winner list. But anyway, to me, it was striking that to the extent we can find identifiable things in, again, I'm a data guy. So, you know, I work with the observable data. I work with accounting data from Kodestad. I work for prior return data from Prisp. Among the things that I can sing myself my teeth into as a statistical guy, income growth stands out as explaining which stocks end up being the big winners. Yeah, and it is interesting if over a really long time period, if a company is increasing their earnings by 25 times, 50 times over a fairly long time period, odds are that's going to deliver pretty strong returns, but say if they double earnings over the next five

Starting point is 00:28:09 years, there's no guarantee that's going to deliver strong returns if it was already priced as a high-growth stock and its P.E's 100. So, yeah, net income growth is certainly an important factor over these long, long time horizons. And I believe in one of your, other interviews, you mentioned lower leverage as one of the things you found. And I would be interested in seeing the data on something like family run companies. I think companies that have a high degree of family ownership over many years, oftentimes you'll see things like lower leverage. They tend to think longer term conservative investments because they view this sort of as a legacy. So I'd be super interested if you've ever looked at any of data related to

Starting point is 00:28:51 that. I've not looked at family-owned companies, but I have a project I'm working on, and I probably won't be able to release it publicly for a little while yet, but it's about CEOs. I'm naming individual CEOs or will be naming individual CEOs in the study, so it's, you know, people could be sensitive. I've got to be very, very careful and get everything right before I release that publicly. But one thing I have, and will be in the study when I release it, is the companies with founder CEOs out before. Not always. ways, of course. But on average, companies with founder, CEOs outperform. So that's not exactly family-owned companies, but somewhat similar. So hope to get that study completed in the next

Starting point is 00:29:32 few months and get it released publicly. And one idea, as I was reviewing your study, I was trying to wrap my mind around was just the length of the study. You know, 1926 to 22 is a long, long time period. And I think if you look at any long time period, almost every company eventually falls by the wayside. And I'm also not going to be an investor for the next 100 or 200 years, most likely. I might hold some stocks for, say, three years. I might hold some stocks for 10 or 20 years. And since you mentioned net income growth being such a key factor to stock returns, I might see a business. Maybe it starts to mature. It starts to see really high levels of competition, just things naturally changed in the marketplace. And then I might decide to exit that company,

Starting point is 00:30:15 for example. I'd be curious to get your thoughts on how, the findings might change if we looked at a shorter time frame. So in many of the studies, I should clarify a little bit, there was this original study that had dated through 2016, then I've had a kind of series of follow-up in studies and extensions. But anyway, in at least some of those studies, I reported things not just for the full sample, the long run, but also in shorter horizons. So in these studies I would have reported on monthly returns, annual returns, decade horizon returns and then full sample or lifetime, lifetime within the database, that is. So you can find

Starting point is 00:30:54 data on shorter horizons in several of the studies. The general pattern is there. Stock returns have positive skewness, but where it really becomes noticeable is at about the decade horizon. So let me back up just a little bit. Many people will be familiar with the normal distribution, the bell curve. We've actually known for a long time, at least six, it's the 1960s that stock returns don't conform to the bell curve. In particular, they're so-called fat-tailed. There's too many really big returns. There's too many really small returns as compared to the bell curve. But that said, when you look at things at the monthly horizon, if you just do a plot of stock returns measured over the monthly horizon, it's not real obvious that there's a strong

Starting point is 00:31:42 asymmetry. You can kind of see it, but it's not real obvious. Even at the one-year horizon, doesn't really jump out at you that there's a strong asymmetry. But once you get to the decade horizon, when you look at returns compounded within a decade, it really does jump out that there's strong asymmetry. And I think most people wouldn't be surprised to hear that stock returns in recent years has also shown that asymmetry. So if we look at just data from 2017 to 2019, for example, just five companies accounted for 22% of the net wealth creation. So in light of your findings in your more recent studies, do you think this makes the case for index investing stronger with things like technology and AI just concentrating in just

Starting point is 00:32:31 these handful of companies? So yes, you're right. The original study showed that there was a lot of concentration in wealth creation. And the follow-up studies have shown that that's becoming even more notable in recent years. Now, does that strengthen the case for an analysis? index investing or not, there's attention here. And I've been asked many times, does your study imply that people should be index investors or more broadly, should you be just broadly diversified by an old type investor? Or should you be active and should be trying to pick stocks? And what I've said is that

Starting point is 00:33:06 I really think that there's a new ammunition here for both sides of that debate. If you were already inclined to think that you should be a diversified by and hold investor or that most people should be diversified by and old investors. You'd look at my study and you'd say, well, we have all the stuff that's already in the textbooks and already been broadly discussed. Now, on top of that, this asymmetry means that if you just pick a few stocks at random, the odds are stacked the institute. You're more likely to lose than when from a few randomly chosen stocks. So anyway, some people, their takeaway is the evidence is stronger than ever that we should be passive, diversified investors. Other people look at it and say, well, we know the markets aren't

Starting point is 00:33:45 perfectly efficient. We know there's at least some opportunities out there. And what this is shown us is how large the payoffs can be if you can successfully exploit your skills or be lucky, to be lucky enough or skilled enough to be able to pick the winners, the payoff to doing that's much bigger than we realized it was before. There's some legitimacy to each side of that debate. The fact that the skewness and the concentration, if anything, seems to be growing in recent years, I think it just strengthes the extent to which each side has more ammunition. Whether it actually makes anybody move from one side to the other, you know, somebody who previously thought it's a good idea for investors with the right skills to be stock pickers, whether any of them will switch to be

Starting point is 00:34:33 passive investors or vice versa. I doubt it. And I don't know that it's really changed my mind either. It's just the strength of the arguments on each side, keep getting stronger. So if I were to argue maybe why someone should want to index, I would point to the fact that it can just be very costly not to own those top 4% of companies. And if you don't own some of those big winners, then it can just be very, very difficult to outperform. But on the other hand, I think one could also argue that there's still a good proportion of companies more broadly that do outperform. and you don't necessarily have to own, say, the Magnificent Seven to do well as an investor. So maybe own the top 0.1% of these companies. And you've mentioned previously you're personally a passive investor.

Starting point is 00:35:21 And I'm sure many of your students want to enter the world of active investing. So I'm curious if there's what sort of advice you tell them or cautionary advice you tell them to help prevent some of the mistakes that stock pickers tend to make. Yeah. So I'm mostly a passive investor. I sometimes deviate from that just a little bit, but it's rare, and it's when I perceive what seems to be an unusual opportunity. But it really comes down, it's an economics phrase, comparative advantage. And if you haven't been sitting in microeconomics courses,

Starting point is 00:35:51 a comparative advantage is actually a really intuitive concept. What are you good at? In particular, what are you better at than the competitors? Some people have the right comparative advantage to be stock pickers or market timers. I'm not sure. sure that that's me, although, like I said, I have occasionally done some active things. And, you know, they've seemed to work out well, but it can be hard to tell the difference between luck and skill in a few tries. But it really comes down to comparative advantage, and then I would say, you know, dwell on the fact, it's not enough to be good, it's not enough to be smart, you have to be better than your competitors. And there's a lot of competition out there. So that's, I think,

Starting point is 00:36:32 the place that people have to ask, that's where they have to start. They have to ask themselves, do I think I have the comparative advantage to do this? You know, the comparative advantage at buying the stock with the right long-term potential that's not already capitalized into the price or being able to time my trays, comparative advantage and being able to live through those drawdowns that are likely to happen, which is kind of part of a psychological question, but also a financial question to be able to live through drawdowns. So that's a big question. You've got to ask yourself, do I have the comparative advantage? for those that do, I say, go for it. As a matter of fact, the economy needs you. It would not be good

Starting point is 00:37:10 if everybody was a passive, diversified index investor. I mean, who's, again, I don't know if the stock buyer's efficient, but to the extent it is, or it's approximately sufficient, it's because active investors are buying undervalued things and selling overvalued things. So if you believe you have the comparative advantage, go for it. The economy needs you, and if you're right. You've got a shot of being rewarded. But here's an analogy that I've brought up a few times. Professional athletics. The payoff, if you have the right comparative advantage, could be huge. But how many people have the right comparative advantage? I mean, I've always enjoyed basketball. I've played basketball recreationally. By a few random events, I ended up in some city leagues

Starting point is 00:37:51 playing with some people who had professional contracts but were not in the NBA. This was their off-season thing. And I marveled at how they could be so good, but not be in the NBA. So to be a successful stock picker, you've got to be good and you've got to be better than your competitors. To a part of advantage is the key issue. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up and customers now expect proof of security just to do business. That's why Vantza is a game. changer. Vanta automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC 2 or running an enterprise

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Starting point is 00:41:31 slash income. This is a paid advertisement. All right. Back to the show. One of the things I see in some of the fund manager letters I read, of course, fund managers have an incentive to say that people shouldn't index, of course. But oftentimes I'll read that they'll point out the increased cost. concentration in the index and point to that as a reason why index funds are riskier today

Starting point is 00:41:59 than they were at different periods in the past. Have you ever looked at data and returns at different points where market concentration tends to be higher and if that, you know, is reflective of what future returns might look like? So I've never done that in the data. And I think that actually it's a desirable thing to put on the to-do list. I have looked at in kind of a more conceptual way, though. I have a paper that's called extending portfolio theory to compound returns. And maybe this is going to be obvious when I say it, but rebalancing periodically is it goes hand in hand with diversification in a sense. So if you started with a well-diversified portfolio, but then you're buying holds from there, we do have this asymmetry,

Starting point is 00:42:45 and some of the stocks are going to do really well, meaning they have a bigger weight in your portfolio, you. Essentially, that's what we've seen with indices like the S-SP 500. The asymmetry is showing up. Some of the stocks have done really well. They've got really heavy weights. Rebalancing by selling those winners and buying some of the stocks that haven't done so well effectively restores your diversification. So to the extent you thought diversification was a good idea in the first place, you might find that trimming your positions in the winters just kind of naturally goes hand-in-hand with the reasoning about why you diversified in the first place. So an index, you know, that has a very high weight on seven stocks is, in some sense, not fully diversified.

Starting point is 00:43:25 I think back to many of the conversations I've had on the show and buying and holding great companies. It can be a big mistake to trim them oftentimes because of just how far they're able to run. And here shortly, I'm going to be mentioning a couple data points from your study, which U.S. stocks generated the highest long-term returns. But before we get to that, has your research in your studies influenced how you've thought about valuation metrics. People often use like price to earnings, price to book, etc. I don't know if it's made any fundamental changes in how I think about them. I mean, they are informative. They are informative measures. We know that they're particular importance to value investors. To not try buy stocks that are not at too high

Starting point is 00:44:09 multiple relative to their earnings. In the studies I did of winning stocks, the ones that ended up in the right tail, I did not find that those valuation metrics had any forecast power for who would end up in the right tail. So people may have been hopeful that that would be a big strong predictor of which stocks end up in the right tail, but I found essentially no forecast power. What I did find is that the stocks that did really well in a given decade had high valuation multiples at the end of the decade. But of course, that's totally different than saying those things can predict. It's a competitive market, there's no easy ways to reliably make money to the extent that those prices relative to underlines reflect that competition. I don't think there's any magic in those ratios.

Starting point is 00:44:53 And my thinking really hasn't been altered on that. Yeah, so I guess my point in the previous question, your most recent study was titled, which U.S. stocks generated the highest long-term returns. And the table of top performers is just mind-blowing, to say the least. So the top performer was Altria. And Ultria, they compounded at 16.2% from 1925 to 2023. So that amounts to a whopping total return of 265 million percent. So tying back to what I was saying earlier with price to earnings or whatnot, someone might have seen excessively high PE sometime along the way and said, hey, this stock's

Starting point is 00:45:34 too expensive, only to see it continue its massive run. And of course, it's an extreme outlier in this database. One of your other top performers from the study was Vulcan materials that compounded at 14% from 1925 to 2023, and that amounted to a total return of 39 million percent. And there's a number of names on this list that our listeners would be familiar with. You have Boeing, S&B Global, Coca-Cola, Deer, Hershey, Johnson & Johnson, etc. And the most surprising thing to me when I look at this is just the duration at which some companies are able to just keep growing and growing and growing.

Starting point is 00:46:10 reminder to me that if you see a great business that has the ability to grow, it likely can maybe run much longer than our intuition might expect. So I think our intuition might say a great company, it's just sort of had its run. And the last 10 or 20 years have been great, but how long can they really keep doing it? So that's kind of what I look at and kind of take away looking at it. I'm curious some of your takeaways looking at this list of top performers. Yeah. So that study a little bit of a back story. I think I mentioned that in several of my studies, I had decided to focus on this dollar-based measure, wealth creation that I called it. And at some point in the last few months, Meb Faber, who I think you know, reached out to me and says, you know, some people are

Starting point is 00:46:55 asking me about which stocks for the highest best performers in just in terms of the buy and old returns. Do you have that handy? And I said, oh, sure, I can get, if I have that handy or I can get that pretty quickly. So I sent him the list. And he mentioned it on Twitter. And then I I started getting a lot of clarifying questions. So I thought, well, okay, I'm going to get these clarifying questions. I should just write up the short paper that describes how I computed these numbers, where they came from and such. So I did that a couple of afternoons have released it, and what I maybe didn't completely anticipate is how interested people are in the list of the big winners. So anyway, that's an interesting phenomenon of itself.

Starting point is 00:47:33 The world wants to know about winners. But the reason I tell the backstory is we've got to keep in mind that these are the stock. that with the benefit of hindsight, I ended up at the top of the list. As we touched on earlier in the podcast, there's thousands of other stocks whose names we wouldn't recognize who ended up with negative 100% returns. But anyway, so we have to keep that in mind. These are the stocks that ended up being the winners. But anyway, I do think there are some lessons that came out of that study.

Starting point is 00:48:01 Some stocks do keep compounding at high rates for long periods of time. Many of them won't. You know, there'll be stocks that had really good returns for a year for five years and then it all falls apart. But it's not impossible. So the fact that a stock has had a run-up in and of itself is not a reason to sell it, nor is it a reason to buy it. I mean, it really comes down to fundamentals. The stock's had a big run-up. Does its current price reflect its future potential? Has the current price gone beyond future potential? Or is it still under the future potential? I mean, ultimately, it's going to come down to those fundamental questions. I had another study that we

Starting point is 00:48:37 haven't touched on yet, where I basically looked at portfolios of stocks that hit certain multiples. Like they hit 5x, or they hit 5x twice to be at 125x, or they did it three times to get to 625x. And I just plotted what did the returns look like before and after hitting those multiples on average. And of course, really good returns before hitting the multiple. That's what got it to the multiple. what happens after it hits the multiple, on average, for portfolio stocks that hit the multiple, they just track the market on average. On average, a stock that's had a run-up does as well

Starting point is 00:49:14 afterwards as a randomly picked stock. It's competitive out there. But the study really shines the spotlight on the importance of time in the market. I mean, the very highest stocks in terms of their cumulative returns for stocks that have been there for 70, 80, 90 years. Of course, you know, Most of us won't be personally investing for 70, 80 or 90 years, so I also looked at some things over shorter horizons, one year, five year, 20 year, horizons. The really high performers, and when you see a stock that's turned in 110% for three years, for example, that's not going to persist in the long run. It never has. The stocks that ended up being like Altria or Volcan Materials, they had good compound returns, 13%, 14%, 16% in that range.

Starting point is 00:50:01 but not crazy good compound returns. If you've seen 50 or 80 or 100%, that's great. That's not going to persist in the long run. Just one of the other thing that I thought was interesting in that list, to be right at the top of that list of highest compound returns, you had to be listed. You had to be on the market for a long time. There were some stocks that wouldn't describe,

Starting point is 00:50:21 you wouldn't immediately say, well, that's a sexy name. You already mentioned one of them. Second on the list was Vulcan Materials. And so I said I could proud that study pretty quickly. they didn't do a lot of research in every stock that was on there. Some of them, of course, we already knew, like say, mowing, speaking of drawdowns. But anyway, back to Vulcan Materials. Just shortly after I released that study, the Financial Times did a podcast, some of their own people, talking about stocks on the list. Vulcan Materials is basically a building materials company. You know,

Starting point is 00:50:49 we're talking sand and gravel and things like that. But they did a very nice job of how pointing out the idea of a competitive moat, which, of course, Warren Buffett likes to focus on a competitive remote that allows a company to continue to generate good income and growing income. Competitive modes could show up in a lot of different ways, one of which is having access to sand and gravel deposits in good locations because the stuff is too heavy to ship a long way. So having in nearby proximity to where it's needed is a big competitive advantage. Anyway, that's not exactly sexy or high tech, but nevertheless, as Olkin is number two on the list of alternative performers. So I think there's some lessons there as well.

Starting point is 00:51:27 Yeah, you do make a great point. about the moat just being so important. If you're looking at a tech company, you know, it's a much sexier industry is going to attract. This industry overall is going to attract all these smart, smart people that are able to figure out how to disrupt some of these technology modes, whereas there's some other names that a lot of these really smart people aren't really attracted to the industry. So some of these established players can really gain a foothold and just grow and grow at steady rates for long periods of time. And you made another great point that when you buy a stock, you don't get paid for anything of what they really did in the past year.

Starting point is 00:52:02 It's all about what they can do in the future and the future is fundamentally uncertain. Pointing to yet another study you've done, a lot of our listeners are not based in the U.S. and they may invest in different markets. Of course, you've looked at international data. So how does the international data look like the U.S. data in terms of skewness and how is it Deferring anyway. That was in my mind one of the obvious follow-on studies. So the original study was focused on the crisp data, U.S. listed common stocks.

Starting point is 00:52:33 I was a natural question to say, is this global phenomenon or is it something that's somehow for some reason unique to the U.S.? So it took a little longer to do. There's some challenges in building a comprehensive database of global individual stock returns. And I wasn't able to do it for as long a horizon. and that was being basically able to get a comprehensive sample that covered a 30 or a little over 30 years. But anyway, the punchline is when I went to the global sample, it looked just like the U.S. sample. As a matter of fact, in terms of the striking findings that most stocks underperform U.S. treasuries

Starting point is 00:53:07 and that the dollar wealth enhancement or wealth creation was concentrated at a few stocks, that was even stronger outside the U.S. than in the U.S. At this point, I'm not surprised. I just, I think I used this phrase earlier in the podcast. I think this strong skewness is just a fundamental attribute of investing in entrepreneurial economies. People often ask me, well, what do you think is going to happen over the next 10 years and the next 20 years? Of course, there's a lot of things I don't know about what's going to happen over the next 10 years or 20 years. I don't know how the overall market's going to do. I don't know which stocks are going to end up on the winners list. But I feel really, really confident in saying there will be skewness over the next

Starting point is 00:53:54 10 or 20 years. There will be a relatively few stocks that generate the bulk of the performance over the next 10 or 20 years. I think the skewn of sorry symmetry is fundamental. I guess I would mention, I'll throw an idea out there and you're free to take it wherever you'd like, but I'm not surprised that some of these international markets have more pronounced skewness, because I would think that just some of these maybe lower quality companies or maybe some of these fraudsters are able to go public in a country like, say, China or India, I'm not sure exactly which country that might apply to, but it seems like the U.S. seems to have stricter regulations about going public. I'm curious to hear your thoughts around that.

Starting point is 00:54:36 Yeah, so I guess I wouldn't jump right to a word like fraudster, but listing standards are definitely relevant here. So one of the findings back in the original paper was that. that the percentage of stocks that ultimately failed, or more broadly, the degree of skewness in the returns was notably stronger for NASDAQ listed stocks or companies that were initially listed on NASDAQ, as compared to companies that were initially listed on the New York Stock Exchange or in the old the MX Exchange. What that tells me is that NASDAQ had different listing standards than the more traditional exchanges did. I would hesitate to use the words the wrong listing standards because in fact, NASDAQ stocks on average, once you take into account that Apple and

Starting point is 00:55:22 Microsoft were for among them, NASDAQ stocks on average actually did very well. But they had higher rates of failure and more skewness. So they had different listing standards. They were willing to list younger and riskier stocks. I think the same phenomenon shows up internationally. Well, this is great, Hendrick. It's great to bring on a data guy to help us sift through this data and share some of the key findings from doing so. So I really appreciate you joining me here and sharing all this great research you've done. So please give a handoff to anyone who wants to read your studies or learn more about some of your work where you can direct them to. Sure. So once the papers get published, they're usually behind a publisher's paywall,

Starting point is 00:56:03 and that could be a barrier, of course. But before the studies are published, they're posted on a publicly accessible bulletin board called Social Science Research Network. SRRN.com. So all the papers we've talked about here are posted on SSRN.com. You can just search under my name or do a keyword search. And that includes the published papers. The final pre-publication version is available on SSRN. All that's changed after that is some formatting and occasionally some really minor changes in wording. So anyway, they're all available on SSRN.com. And if you're interested, you can download them and happy to receive comments. Wonderful. Well, I'll be sure to get that linked in the show notes for anyone that wants to check it out. There's a lot of interesting stuff in there and had a lot of fun. Sifting through those for this conversation. So Hendrick, thank you for joining me. I really appreciate it. My pleasure. Thanks for having me. Thank you for listening to TIP.

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We Study Billionaires - The Investor’s Podcast Network - TIP667: Why Most Stocks Will Lose You Money w/ Professor Hendrik Bessembinder

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