The Evidence-Based Investor

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  1. Why owning losing stocks doesn’t matter

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    A common criticism of index funds is that they own losing stocks as well as winners. It’s true, they do. But does it actually matter?

     

    Every investor loves a winning stock. As for losing stocks, most investors, given the choice, would avoid them like the plague.

    It’s perfectly natural that we should feel this way, both from a neurobiological and a behavioural perspective. Winning stocks activate the brain’s reward system, releasing dopamine, a neurotransmitter associated with pleasure and reward. Losing stocks can induce the release of cortisol, a stress hormone, which often results in heightened anxiety and fear. Also, because of a bias called loss aversion, investors tend to experience the pain of losses more intensely than the pleasure of equivalent gains.

    But what if we told you that owning losing stocks is inevitable, and that coming to terms with that fact will help you to achieve your investment outcomes?

     

    Most (yes, most) stocks are losers

    Strange as it may seem, the vast majority of stocks are losing stocks. Yes, you read that correctly. A study by Professor Hendrik Bessembinder from the WP Carey School of Business at the University of Arizona, analysed the performance of more than 26,000 US stocks between 1926 and 2019. What he found was that, although the overall U.S. stock market has outperformed Treasury bills (or US government bonds) in the long run, most individual stocks have not. Specifically, less than half of the stocks he analysed generated positive lifetime returns, and only 42.6 percent outperformed one-month Treasury bills.

    How, then, can we explain the fact that U.S. stock markets nevertheless delivered very positive returns to investors during that period? The answer, says Bessembinder, is that the market’s net gain was driven by a small percentage of highly successful stocks. Indeed, market returns were wholly driven by only the top four percent of companies.

    In other words, Bessembinder’s research provides strong evidence of what statisticians call positive skew in the stock market. Simply put, the best-performing stocks have experienced outsized returns relative to the rest of the market.

    READ THE FULL ARTICLE HERE

     

    PREVIOUSLY ON TEBI

    Here are some other recent posts you may have missed:

    What did Benjamin Graham think about market timing?

    Public pensions are failing investors and taxpayers

    Surviving ten years is a challenge for active funds

     

    TEBI ON YOUTUBE

    Have you visited the TEBI YouTube channel lately? There’s already a wide selection of high-quality videos on there. Why not subscribe and be one of the first to see our latest content? You’ll also find our videos on Instagram and TikTok.

     

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  2. Style drift — a lesser-known downside of using active funds

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    One of the downsides of using actively managed fund is what’s called style drift. It’s a widespread phenomenon, and, unless you’re looking out for it, the danger is it can give you a nasty surprise.

     

    Many of us learned a new skill during the Covid pandemic, and for me it was cooking from scratch. I love the simple pleasure of choosing fresh natural ingredients and then turning them into a nutritious meal. I’m not an expert cook, believe me, but I’ll never go back to buying processed food with long lists of obscure ingredients.

    There are close similarities between food and investments. Building a portfolio is rather like shopping for groceries. You can either fill your cart with wholefoods like organic meat, wild-caught fish, fresh fruit and vegetables, nuts, grains and legumes. Or you can buy pre-packaged food you can just put in the microwave — yes, far more convenient, but not very good for your long-term health.

    Actively managed mutual funds can be rather like convenience foods. They’re often heavily advertised and made to look as though they’re much better for us than they are. Worse still, you may get a nasty surprise when you discover what they actually contain.

    In fact, the labeling of investment products can be even more misleading than food labels. Take equity funds, for example. Stocks come in many varieties. There are large-cap, mid-cap, small-cap and micro-cap stocks, growth stocks, value stocks, momentum stocks, low-volatility stocks, high-dividend-yielding stocks — the list goes on.

    The problem, as Mark Hebner explains in Step 6 of his book Index Funds: The 12-Step Recovery Program for Active Investors, is that no industry-wide standards exist for defining these terms.

    “To make matters even more difficult,” Hebner writes, “carefully crafted fund prospectuses give active fund managers significant leeway to deviate from their fund’s stated investment style. As a result, companies with divergent risk and return characteristics are often lumped together into the same style.”

    The phenomenon Hebner is referring to is called style drift.

    READ THE FULL ARTICLE HERE

     

    PREVIOUSLY ON TEBI

    Here are some other recent posts you may have missed:

    What did Benjamin Graham think about market timing?

    Investors look for patterns that don’t exist

    Learn to tame your inner chimp

     

    JOIN THE CONVERSATION

    So what do you you think of this content? Follow TEBI’s founding editor Robin Powell on social media and join the debate. We would love to hear your views. We’re on Twitter, LinkedIn and YouTube.

     

    © The Evidence-Based Investor MMXXIV

     

     

  3. Should you go all in on equities?

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    For at least the last 70 years or so, there have been two guiding principles of portfolio management. The first is that you should spread your risk between different asset classes, with the general consensus being that those should be principally equities and bonds. The second principle is that, as you get older, you should gradually reduce your exposure to equities and increase your exposure to bonds.

    These two principles are easy to understand and are now so deeply ingrained in us that they are hardly ever challenged. But what if it’s time for a rethink? Indeed, what if these sacred principles weren’t such great ideas all along?

    A paper published later last year explores optimal asset allocation and suggests that a portfolio holding 100% stocks and no bonds at all is generally best, even if (wait for it) you’re already in retirement.

    The paper is entitled Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice, and it was authored by three finance professors in the United States — Scott Cederburg from the University of Arizona, Aizhan Anarkulova from Emory University, and Michael S. O’Doherty from the University of Missouri.

    READ THE FULL ARTICLE HERE

     

    PREVIOUSLY ON TEBI

    Here are some other recent posts you may have missed:

    DIY financial advice is a big risk

    The power of doing nothing

    Diversify, diversify, diversify

     

    HAVE YOU READ THIS BOOK?

    Robin Powell and Jonathan Hollow have been friends since childhood and share a passion for helping people understand the world of money, savings, pensions and investments.

    Now they’ve authored a book called How to Fund the Life You Want, which explains in plain English what you need to know to pay for the life you want to lead.

    The book is published by Bloomsbury and is primarily written for a UK audience.

    It’s available to buy on Amazon, on Bookshop.org, and in all good bookshops. There’s an eBook and an audio book version as well.

     




     

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  4. Financial advertising can seriously harm your wealth

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    It’s hard to escape financial advertising. The biggest brands seem to get their name all over the place, from the side of taxi cabs to train station billboards. They sponsor arts and sporting events and take out full-page adverts in newspapers and magazines.

    There’s a reason why banks and fund management companies spend so heavily on advertising: it’s actually very effective. Why? Well, people are naturally anxious about money. Many find the idea of the financial markets quite scary. They’re bombarded with information, not least on social media, and they’re confused by all the different options. So they derive comfort and security from large, familiar brands, and they’re especially receptive to simple marketing messages that help them make decisions.

    Even if you consider yourself a relatively sophisticated consumer, you may be more susceptible to financial advertising than you think. The reason is that financial advertisers are very clever at exploiting our vulnerabilities and lack of understanding. They also know just the right buttons to press to make us sit up and take notice.

    But financial advertising can seriously damage your wealth, so you need to stay on your guard. Here are five ways in particular in which financial advertisers seek to influence investors’ decision-making.

    READ THE FULL ARTICLE HERE

     

    PREVIOUSLY ON TEBI

    Here are some other recent posts you may have missed:

    Channel your inner Mr Spock

    How to think like a scientist

    Investment perfection doesn’t exist

     

     

    FIND AN ADVISER

    The evidence is clear that you are far more likely to achieve your financial goals if you use an adviser and have a financial plan.

    That’s why we offer a service called Find an Adviser.

    Wherever they are in the world, we will put TEBI readers in contact with an adviser in their area (or at least in their country) whom we know personally, who shares our evidence-based investment philosophy and who we feel is best able to help them. If we don’t know of anyone suitable we will say.

    We’re charging advisers a small fee for each successful referral, but you will pay no more than you would if you contacted the adviser directly.

    Need help? Click here.

     

    © The Evidence-Based Investor MMXXIV

     

     

     

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