During the third quarter, the U.S. Federal Reserve Board (the “Fed”) reduced short-term interest rates, marking a shift in interest rate policy from the prior four years. For much of that time, the Fed was worried about inflation. When the Fed raised interest rates, it intended to cool the economy and reduce inflation. With inflation back to more normal levels, investors correctly speculated the Fed’s next step would be also to bring down short-term interest rates.
The investment community generally likes lower interest rates, partly because the lower borrowing costs for consumers and businesses boost economic activity. As is often the case, investors didn’t wait for the Fed’s decision (announced September 18). The asset classes in your portfolio produced strong returns in the third quarter, with much of the gains occurring before the Fed’s announcement. For the year, all equity asset classes, such as stocks and real estate securities have produced double-digit percentage returns while bonds have generated returns in the mid-single-digits.
“Do Stocks Outperform Treasury Bills?”
Market concentration has been a hot topic recently. A handful of companies — familiar technology names such as Apple, Microsoft, Nvidia, and Amazon — have accounted for a significant portion of overall market returns in the past few years. We’ve commented on this phenomenon in past quarterly letters and focused primarily on the risk that concentration poses to investors in the future. If a few of these companies stumble or underperform expectations, broad U.S. market returns may likewise disappoint. But the other side of this coin is worth exploring. Owning these companies has been vital to achieving the higher returns made possible by investing in stocks.
A paper by Hendrik Bessembinder1, an Arizona State University professor, provides a historical perspective on this issue and reaches a startling conclusion. The majority of stocks over the last roughly 100 years produced returns no better than those of U.S. Treasury Bills (generally a low return and much safer investment alternative). Therefore, the “market” return came from a relatively small number of highly successful companies. Quoting the author: “During the full 1926–2019 period, just five firms account for 11.9% of net U.S. stock market shareholder wealth creation and eighty-three firms (out of more than 26,000) account for half of stock market wealth creation.”
My most important takeaway relates to the motivation for diversifying a stock portfolio. Investors typically think of diversification as a means of reducing risk. Bessembinder’s research points to a different reason. A broadly diversified stock portfolio ensures you own the stocks that wind up producing terrific returns. The research bolsters the case for investing in index funds and provides a warning for those picking individual stocks. Index funds own the broad market and ensure investors have exposure to the eventual winners. Picking individual stocks heightens the risk of missing would-be market leaders. Even professional investors have not demonstrated the ability to outperform the market with their stock picks.
Downside Risk
Now we turn our attention to a different element of stock market behavior — downside risk. We show the chart below in our initial portfolio design sessions with new clients. It illustrates annual U.S. stock returns2 since 1980 (blue bars) and the intra-year decline in each of those years (orange diamonds). Notice while the majority of these years resulted in positive returns, investors still experienced price declines within each year. Annual returns are positive in 33 out of the 44 years, and yet investors, on average, experienced a -14% price decline sometime within the year.
The chart reminds us that stock investing is more emotionally challenging than we might otherwise conclude from historical annual return information. Bad years were worse than you may remember. For instance, 2008 resulted in a loss of -37% but investors had to endure a roughly -50% price decline within that year. And some good years also may have been worse than you remember. One such example is 2020. The first year of the pandemic finished with positive stock returns (up approximately 16%). Still, those gains only accrued to disciplined investors who withstood a greater than -30% intra-year decline in the value of their stock holdings.
I raise this point because last year and this year featured relatively minor pullbacks. Due to uncertain timing, some larger price corrections loom out in the distance. This fact is not a call for action but rather a reminder that successful long-term stock investing requires patience and discipline. As always, we look forward to our next conversation.
Sources:
1 “Wealth Creation in the U.S. Public Stock Markets: 1926 to 2019”
2 Price-only returns for S&P 500 (does not include dividends) © Gibson Capital, LLC. Compiled with data from J.P. Morgan Asset Management
