When we dive into the world of stock returns, it’s easy to assume that individual stocks will consistently bring in positive results. After all, historical trends show that the stock market often outperforms other asset classes, like bonds. But a recent study by Henric Bessembinder, published in the *Financial Analysts Journal* in April 2023, sheds light on a surprising reality: the **median monthly return** for a wide range of individual stocks is actually zero.
This statistic tells a more complex story about stock performance—half of the stocks generate positive returns, while the other half fall short.
Contextualizing Stock Performance
In my Deutsche Bank experience, I’ve observed firsthand the ups and downs of financial markets. The 2008 financial crisis serves as a stark reminder of the risks involved in investing, highlighting the importance of understanding stock performance metrics. The fact that the median return for individual stocks hovers around zero raises some critical questions for both investors and advisors. If we were to view stock performance solely through this lens, convincing clients to invest in equities would undoubtedly be a tough sell, especially for those chasing short-term gains.
However, there are various ways to evaluate stock returns beyond just looking at median performance. A common approach involves analyzing returns in relation to volatility—a measure of price fluctuations, often represented by standard deviation. On average, the annual standard deviation of stock returns sits at around 50%. This level of volatility means that an individual stock’s price can swing widely throughout the year. Applying the 95% confidence interval typically used in statistics, we find that an individual stock’s return could vary by approximately +/- 100% within a single year. That kind of variability can be daunting; it suggests that a stock could either double in value or lose it all within just 12 months.
The Long-Term Perspective on Stock Returns
This inherent uncertainty might deter potential investors, particularly those who value stability. The idea that individual stocks represent a “half-full, half-empty” scenario on a monthly basis, coupled with annual volatility, could make anyone hesitant to step into the market. Yet, it’s crucial to remember that stocks are primarily designed for long-term investment. Those unsettling short-term fluctuations are part of the broader journey toward wealth creation over time.
Shifting our focus to long-term stock returns raises an interesting question: shouldn’t we expect more consistency over extended periods? Bessembinder’s research also explored long-term stock performance, revealing some sobering findings. About **55% of US stocks** underperformed compared to US Treasury Bill returns, which means that more than half of individual stocks have lagged behind some of the safest government-backed investments. Even more concerning is the fact that the most common outcome for individual stocks is a total loss—essentially, a complete failure.
Understanding Skewness in Stock Returns
Typically, when analysts assess stock performance, they focus on two key statistical measures: central value (mean or median returns) and volatility (as indicated by standard deviation). This traditional framework often paints a discouraging picture of individual stock investments. If short-term returns are predominantly zero, medium-term returns are highly volatile, and long-term prospects seem risky, one might wonder: what’s the point of investing in stocks?
Yet history shows us that, despite these challenges, stocks have consistently outperformed other asset classes like bonds and cash over the long run. To understand this phenomenon, we need to look beyond conventional analyses that emphasize central value and volatility. A key aspect of stock return distribution is **positive skew**, which explains why stocks have historically outshone other investments.
Focusing solely on central value and volatility assumes that stock returns follow a normal distribution, much like a bell curve. However, this assumption falls short when we consider stock returns, which are heavily influenced by the often-irrational behaviors of human investors. Unlike natural occurrences that display predictable patterns, stock prices reflect a complex mix of emotions—fear, greed, speculation, optimism, and panic.
This emotional landscape leads to the phenomenon of positive skew in stock returns. While the downside for any stock is capped at a 100% loss, the upside potential is theoretically limitless. An investor might lose everything on one stock, but another could skyrocket, delivering returns of 200%, 500%, or even more. It’s this asymmetry in returns—the potential for gains to exceed losses—that creates positive skew.
Moreover, the magic of multi-period compounding highlights the value of investing in stocks. Stock return distributions show that the long-term value from market investments mainly arises from tail events—those rare, extreme occurrences at both ends of the distribution. The long, positive tail is what accounts for the outsized returns that compensate for the frequent, smaller losses. For stocks to deliver the high returns we’ve historically seen, those substantial positive tail events must outweigh the significant negative ones.
Interestingly, traditional portfolio management strategies often aim to reduce volatility by limiting exposure to extreme events. While this approach seeks to create a more stable and predictable return stream, it can inadvertently suppress both significant losses and substantial gains. This reduction in positive skew ultimately leads to lower overall returns. For example, a typical “Managed Equity” strategy might eliminate all stock losses (capping returns at zero) while simultaneously limiting upside potential. Such strategies can yield paltry returns when the broader market experiences significant growth.
In essence, avoiding emotional tail events means missing out on the very returns that drive long-term wealth creation. Investors who focus too much on smoothing returns may find themselves with more consistent, yet substantially lower, returns over time. To truly unlock the potential of stock investing, one must learn to embrace the emotional ups and downs that come with the territory. Accepting volatility and the inevitability of tail events is crucial for achieving those high returns.
Ultimately, the most successful investors grasp the significance of volatility and the role of tail events in their investment journeys. By embracing the concept of positive skew and the associated tail events, investors can tap into the full spectrum of stock market gains. It’s essential to cultivate a mindset that appreciates, rather than fears, the skew.
