Why Investment Returns Should Decline

A number of investment firms have argued that investment returns, especially stock returns will be below the long-term averages over the next 10 years. The main reason is that Federal Reserve policies after the financial crisis artificially boosted stock returns the last few years.

Here’s another argument for lower investment returns over time. This argument doesn’t have anything to do with the financial crisis or Fed policy. Instead, it argues that as market develop and people are more comfortable with the history of markets, they’ll view stocks as being less risky. That would push up their valuations and reduce their excess returns over cash. It also argues that this has been happening over the decades and will continue.

Dr. Hendrik Bessembinder of Arizona State University recently published a fascinating study in which he examined the return profiles of individual equity securities across market history.  He found that the performance is highly positively skewed.  Most individual stocks perform poorly, while a small number perform exceptionally well.  The skew is vividly illustrated in the chart below, which shows the returns of 54,015 non-overlapping samples of 10 year holding periods for individual stocks:

The majority of stocks in the sample underperformed cash.  Almost half suffered negative returns.  A surprisingly large percentage went all the way down to zero.  The only reason the market as a whole performed well was because a small number of “superstocks” generated outsized returns.  Without the contributions of those stocks, average returns would have been poor, well below the returns on fixed income of a similar duration.  To say that individual stocks are “risky”, then, is an understatement.  They’re enormously risky.