The Power Law proposes that the majority of output in any given circumstance comes from a minority of inputs.
Within stockmarkets, the Power Law is in full swing.
At the time of writing, the US stockmarket (as per the S&P 500 equity index) is up c. 23% year-to-date. But the vast majority of that return has been driven by just a handful of stocks – the ‘magnificent 7’ (Amazon, Apple, Facebook, Google, Microsoft, Nvidia and Tesla) are up 108% on average, whereas the rest of the index has gained ‘just’ 5%.
That level of concentration doesn’t feel right and has prompted warnings of an impending correction in the technology sector. However, history suggests that this is indeed the norm over the long run.
The endurance of the Power Law
Recent studies from Arizona State University and NYU found that:
- All of the wealth creation in the US stockmarket since 1926 came from just 4% of stocks – the other 96% are statistically irrelevant,
- Nearly 60% of stocks failed to outperform 3-month treasury bills (a proxy for cash),
- 55% of all stocks are losers over 10-year timeframes. However, the winners have more than made up for these, resulting in a positive average return for the index as a whole. For reference, the average long-term return for the S&P 500 is around 10% per year.
The key point is that the bulk of long-term stockmarket returns come from a surprisingly small number of companies.
Those companies will change – the top 10 performers in one decade are very rarely the best performing in the next one - however, it’s still a tiny cohort of companies that typically drives overall performance.
The perils of picking stocks
It follows that individual stock picking is really hard, due to the dangers of missing out on the ‘select few’.
Imagine a concentrated portfolio of say 10-20 companies:
- If you get it right and hold a couple of big winners, the returns can be massive.
- But holding concentrated positions inevitably increases the risk of you underperforming by a wide margin – evidence suggests that the probability of successfully identifying the next big winner and running this for the long-term (i.e. not banking profits too early), is extremely small.
- We also observe that most UK investors exhibit a high domestic bias (i.e. they’re significantly overweight UK stocks). By fishing in such a small pond – the UK now represents just 4% of the global stockmarket - the chances of success are reduced further.
…and the benefits of passive investing
Conversely, one way to ensure you have exposure to the big winners (whoever they are) is to own the whole market via passive funds.
“Don’t look for the needle in the haystack. Just buy the haystack" [Jack Bogle, founder of Vanguard]
At Blincoe, we favour a mainly passive-based approach, one that largely tracks the market but with a modest ‘tilt’ towards small caps (i.e. smaller companies vs large), value stocks (companies trading at relatively cheap valuations vs expensive) and consistent profitability (based on firms’ operating profits over book equity ratios) - three so-called factors that have consistently outperformed over the long-run.
Please click here if you’d like to learn more about our investment philosophy, or get in touch if you're interested in a chat.
Investment Risks: When investing, your capital is at risk. The value of your investment (and any income from them) can go down as well as up, and you may get back less than you invested, particularly where investing for a short timeframe (we normally recommend a horizon of at least 5 years). Neither simulated nor actual past performance is a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
Disclaimer: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
