Do Stocks Outperform Treasury Bills?

It would be easy to think of that question as rhetorical. And yet, new research concludes otherwise.

Even the paper’s author, Hendrik Bessembinder of the Department of Finance, W.P. Carey School of Business at Arizona State University, acknowledges that the question posed in the title of this paper may seem nonsensical, noting that the fact that “stock markets provide long term returns that exceed the returns provided by low risk investments such as government obligations has been extensively documented, for the U.S. stock market as well as for many other countries.” He explains, “The degree to which stock markets outperform is so large that there is wide-spread reference to the “equity premium puzzle.”

Bessembinder states that while the evidence that stock market returns exceed returns to government obligations in the long run is based on broadly diversified stock market portfolios, “Most individual U.S. common stocks provide buy-and-hold returns that fall short of those earned on one-month U.S. Treasury Bills,” which he says implies that the “positive return premium observed for broad equity portfolios are attributable to relatively few stocks.” He claims that, of all monthly common stock returns contained in the Center for Research in Securities Prices (CRSP) database from 1926 to 2016, only 47.8% are larger than the one-month Treasury rate. Indeed, he claims that less than half of monthly CRSP common stock returns are positive.

Focusing on stocks’ full lifetimes (from the beginning of sample or first appearance in CRSP through the end of sample or delisting from CRSP), just 42.6% of common stocks, slightly less than three out of seven, have a buy-and-hold return (inclusive of reinvested dividends) that exceeds the return to holding one-month Treasury Bills over the same horizon. The paper notes that more than half of CRSP common stocks deliver negative lifetime returns.

That said, the research acknowledges that the median time that a stock is listed on the CRSP database between 1926 and 2016 is a mere seven and a half years, and that therefore, to assess whether individual stocks generate positive returns over the full 90 years of available CRSP data, Hendrick conducted “bootstrap simulations.”

Simply put, he concludes that very large positive returns to a few stocks offset the modest or negative returns of what he says are “more typical” stocks, and furthermore that the importance of this positive “skewness” in the cross-sectional return distribution increases for longer holding periods, due to compounding.

Bessembinder notes that, at least in terms of lifetime dollar wealth creation, the entire gain in the U.S. stock market since 1926 is attributable to the best-performing 4% of listed companies. He says that these results help to explain why active strategies, which tend to be poorly diversified, most often underperform market averages.

When stated in terms of lifetime dollar wealth creation to shareholders in aggregate, he states that approximately one third of 1% of the firms which have issued common stocks contained in the CRSP database account for half of the net stock market gains, and slightly more than 4% of the firms account for all of the net stock market gains. The other 96%? Bessembinder claims that those firms which have issued stock collectively matched Treasury-Bill returns over their lifetimes.

Of course, if the positive returns are attributable to only a few stocks, Bessembinder notes that this reaffirms the importance of portfolio diversification, “particularly for those investors who view performance in terms of the mean and variance of portfolio returns.”

Bessembinder maintains that his results show that individual stocks and portfolios containing relatively few stocks have “positively skewed returns,” particularly over multiple-month horizons. Moreover, since diversification tends to eliminate this skewness, he says that investors may rationally choose to hold portfolios that are not well diversified. Bessembinder says the results of his analysis show that the returns to active stock selection can be very large, “if the investor is either fortunate or skilled enough to select stocks that go on to earn extreme positive returns.”

Bessembinder concludes by noting that the key question is “whether an investor can reliably identify such “home run” stocks, or can identify a manager with the skill to do so.”

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