How to manage stockmarket risk

The lowest-risk investment any earthling can make is lending money to the U.S. government for just 30 days. This investment is done through a One-Month U.S. Treasury Bill, a government-backed instrument that has minimal risk.

The yield on a U.S. Treasury Bill essentially sets the benchmark for how all investment risks are priced. For example, it’s common for other investments to offer a return that is a fixed margin (e.g., 3.0%) over the U.S. Treasury Bill rate, which is currently 4.1%.

When you invest in public stock markets like the Australian Stock Exchange or Nasdaq, you reasonably expect higher returns compared to the US Treasury Bill rate because you’re taking on more risk. But what is the reality?

In 2018, a comprehensive academic study[i] analysed the performance of all 26,000 stocks listed on U.S. stock exchanges from 1926 to 2016. Here are the key findings:

  • Extreme Positive Returns - Only 4% of the stocks outperformed U.S. Treasury Bills by a significant margin. In other words, the best returns were concentrated in a very small number of companies.

  • Most Stocks Fail to Outperform - 58% of stocks failed to outperform the One-Month U.S. Treasury Bill. This means that, for over half of the stocks, holding them from their listing date until their delisting did not generate a return higher than the world’s lowest-risk asset.

  • Market Performance - The top 4% of stocks (around 1,092 in total) were responsible for all net wealth creation. The returns from the remaining 96% of stocks collectively mirrored the performance of U.S. Treasury Bills.

  • Some Huge Winners - Just 86 stocks (0.33% of the total) were responsible for half of the total wealth creation, amounting to a staggering US$16 trillion.

Does This Mean You Should Avoid Stock Market Investing?

Not at all. However, these findings underscore the critical importance of diversification in any investment portfolio, especially for those relying on their investments for long-term cash flow after they stop working.

Sure, if you could identify and hold the 0.33% of stocks that deliver spectacular returns, that would be ideal. But as this article remind us, even the most carefully selected stocks may not always yield the expected outcomes: https://loricapartners.com.au/insights/the-perils-of-buying-direct-stocks

The Power of Diversification

Investing in equities requires assurance you own the winners to generate resilient long-term returns. The best way to achieve this is through low-cost, well-diversified portfolios.

As financial advisers, our responsibility is to create investment strategies and portfolios that give our clients the highest probability of achieving their financial goals. The data clearly illustrates the need for a thoughtful, diversified approach to investing. This is the foundation of effective long-term wealth management.

 

Author: Rick Walker

[i] Do Stocks Outperform Treasury bills? by Professor Hendrik Bessembinder, Department of Finance, W.P.Carey School of Business, Arizona State University, May 2018

Rick Walker