Today, we have about 4,000 publicly traded companies in the U.S. stock market and, according to the World Bank, nearly 40,000 companies around the globe, each with their own destiny in an ever-changing world. How can we identify the stocks that are likely to grow and prosper in the coming years so that our financial accounts will as well?
Do The Homework
We could study the market, using the abundance of data on the internet today, and there is no shortage of helpful advice for how to do the homework. However, it’s unlikely that we’ll discover anything that isn’t already factored into current stock prices by the traders and algorithms at the banks, brokerage firms, and professional fund managers.
Even if we could, concentrating our investment bets in a handful stocks could leave our portfolios dangerously undiversified. Who knows if our selected companies will even be around in a few years, since the average corporate lifespan has been plummeting - from 61 years in 1958 to 18 years half a century later, according to a McKinsey study a few years ago. McKinsey predicted, moreover, that 75% of the companies in the S&P 500 Index would disappear by 2027 - bought-out, merged, or bankrupted out of existence.
“No problem,” a furniture salesman told me years ago, when I preached the virtues of diversification. “I own the most diversified mutual fund in the world.”
“What’s that?” I asked, as he rang up the purchases.
“GE.”
What he meant was that General Electric, formed in 1892, manufactured products in so many industries - from light bulbs to lasers and jet engines - that an investment in its stock was inherently diversified. A few years later, its stock price fell over 80%, as the company was toppled by problems in its finance division. The stock never fully recovered and a couple years ago suffered the fate of being the last original member to be removed from the Dow Jones Industrial Average.
Hire a Manager to Do the Work for You
We could hire a mutual-fund manager to pick the stocks for us. However, there are twice as many U.S. mutual funds today as there are U.S. publicly traded companies - about 8,000 funds altogether - so again, how to choose?
The traditional method is to look for the funds with high returns, and you don’t have to look far to find this year’s outperforming funds. If you want to look at longer track records, you can use a service such as Morningstar to examine 3, 5 and 10-year fund performance.
However, as we’ve noted before, even these longer track records aren’t much help in identifying which managers will outperform going forward. The main reason is that it’s difficult to know whether a fund manager’s good performance resulted more from skill that’s likely to persist rather than luck that could run out.
To illustrate the problem, imagine a stadium full of a thousand socially distanced fund managers standing next to their seats. They flip a coin and the ones who come up tails have to sit down. Since the odds of getting tails are 50%, half the managers have to sit. The remaining managers repeat this process several times until only a few are left standing. These are the ones with the best performance records, but it’s easy to see that they arrived in the winner’s circle by pure chance.
In the real world, how do we know whether a fund manager got to the winner’s circle through skill or the equivalent of coin flipping? It’s tough, since luck can persist for quite a while before running out. At one point, famed Legg Mason manager Bill Miller had beaten the S&P 500 Index every year for fifteen years from 1991 to 2005. If he had retired right then, he’d still be a legend today. Instead, over the next three years, he became a cautionary tale, performing so badly that he destroyed his entire track record and never recovered.
This is the fate of most managers trying to beat the market. The longer the investment period, moreover, the more likely a manager is to underperform, which is a concern for anyone trying to shepherd their portfolios across several decades.
Buy the Market
Why not just buy the market itself by purchasing an index fund that tracks one of the popular market indices such as the S&P 500 Index or Russell 3000? This is a smart choice and the one popularized by John Bogle, founder of The Vanguard Group, who created the first retail index fund in 1976.
Better yet, investors can build a low-cost, globally diversified portfolio by using a collection of only three mutual funds - for U.S. stocks, international stocks, and bonds. This three-fund approach is likely to outperform many other more complicated and expensive approaches, and its simplicity makes it easy to implement, which is why we recommend it for anyone wanting to manage a portfolio themselves.
However, it’s a much narrower bet than it seems. Despite the funds holding thousands of companies, the portfolio’s performance is nevertheless dominated by a handful of companies whose enormous market size means that their price fluctuations overwhelm the effects of most other companies in the portfolio.
Consider, for example, the difference in size between the largest and smallest companies in the S&P 500 Index - Apple (AAPL) and News Corporation (NWS), owner of the Wall Street Journal:
Apple’s $2 trillion dollar valuation means that if its stock price drops even a smidgen, the whole market can feel its effects. Meanwhile, News Corporation could probably cease to operate without causing a ripple in the market.
This problem of stock concentration is even worse when we consider that the top six companies in the S&P 500 Index are worth as much as the next 300 companies. These few companies have, moreover, been one of the primary engines of growth for the index’s positive returns for nearly a decade.
You can see the effect in the chart below, where the red line represents the investment returns of Facebook, Amazon, Apple, Netflix, Google (Alphabet) and Microsoft compared to the returns of all the remaining companies:
Most investors holding the S&P 500 Index are probably betting a lot more than they realize on the returns of these few companies.
Factor Investing
Is there a way to harness the power and simplicity of the market while diversifying away from its concentrated bets on the large companies? Yes, investors can buy the market with part of their portfolio and combine this with other types of stocks that offer diversification benefits.
The evidence for these benefits has been accumulating since the 1960’s. As computers and data came online, financial economists, noticing that stock prices vary, asked a simple question: Why do some kinds of stocks offer higher expected returns than others? Over time, as Chicago professor John H. Cochrane has put it, researchers built “better telescopes” to identify the underlying drivers of stock returns, which they call “factors.”
The basic concept is simple and can be described by thinking about the difference between a stock and a bond. Most people understand that stocks offer higher expected returns than bonds, because stocks are riskier.
Why are stocks riskier? For one thing, stockholders can lose their entire investment if a company goes bankrupt, whereas bondholders often get back some of their money, since bonds are secured by company assets. To compensate for the risk of losing everything, stocks need to offer higher expected returns than bonds -- a “premium” over bonds -- to attract investors.
Within the market itself, certain types of stocks historically have offered a premium over other types, presumably to compensate for their higher risks. These factor groupings, moreover, have tended to move in different ways over time, which means they offer diversification benefits.
The success of combining different types of stock factors has spawned a gold rush in academia to discover new sources of investment returns. As a result, there are today over 500 reported factors in the research literature amounting to what has been called a “factor zoo.”1
Fortunately, we can ignore most of them and focus on a handful of the best-documented and most easily implemented factors offering investment-return premiums:
Market Factor - the premium, discussed above, that stocks offer over bonds.
Value Factor - a premium offered by stocks with low prices relative to their company values.
Size Factor - companies with small market capitalization historically have provided greater returns than larger companies.
Profitability Factor - companies that exhibit strong operating profits have, despite relatively high stock prices, offered more robust returns than other “growth” stocks.
The factor jargon sounds complicated, but the implementation of a factor-enhanced portfolio is straightforward. A common approach is to combine the market itself with “overweights” to other types of stocks within it:
The goal of overweighting these other types of companies is to access the different sources of investment returns that they offer, rather than having their effects overshadowed by the large companies ascendant at the time. Historically, the diversification benefits offered by this approach have helped investors achieve similar returns to the market itself, with less volatility, resulting in better risk-adjusted returns.
This factor-enhanced approach is not a free lunch, though. There’s always a risk that a more diversified portfolio will underperform the market, and there have, in fact, been long periods of time when this has happened.
This is a risk that comes with all investment strategies, though, and investors often forget that there have been times when the S&P 500 Index has itself failed even to keep up with the returns on cash (U.S. Treasury bills), including three long stretches from 1929 to 1943, 1966 to 1982, and 2000 to 2012.
As Larry Swedroe has noted, these three periods of underperformance total 45 years, or half of the 90 calendar years since 1929. Meanwhile, in each of these three periods, “value provided diversification benefits, outperforming the S&P 500.”2
Whether you decide to proceed with a market-based approach or to enhance your portfolio by diversifying across other stock factors, the key is to pick a strategy and stick with it. While it’s anybody’s guess which approach will outperform in the coming year, one thing we do know is that chasing performance by flip-flopping between strategies is the surest way to underperform.
1 See “A Census of the Factor Zoo", 2019, Harvey & Liu (“The rate of factor production in the academic research is out of control.”).
2 Larry Swedroe, SeekingAlpha, June 18, 2020, “Is The Value Premium Dead?"