Parrondo’s paradox states that by combining two losing bets that a winning bet can be created. The math proves that if the bets are placed in a specific order and are independent than a strategy exists that will be profitable. A version of this is the bedrock of Modern Portfolio Theory that diversification produces a better risk adjusted return even if the last addition of an asset has a lower expected return than the portfolio.
Critics of Parrondo’s Paradox state that if the game is stripped down it leaves three simple games; two have a possibility of losing and one that has a high probability of winning. The same logic can be used to deconstruct Modern Portfolio Theory, a portfolio consists of a few investments that have a high probability of winning along side many investments that have a probability of losing. The probability distribution of winning investments is much more skewed than theoretically rational investors appear to believe.
Hendrik Bessembinder’s 2018 paper titled Do Stocks Outperform Treasury Bills? dealt with the skew of the public markets and while he was not the first to point it out, his work shone a light on some underutilized statistics.
He concluded that long term wealth creation in the stock market has been driven by 4% of the stocks while the most common outcome for public equities is a total loss. He demonstrated that the skew grows larger over longer time periods because of compounding. The skew coefficient for the stocks added to the S&P 500 during 1977-1986 that still remain is over 40, a stunning statistic. That group contains Microsoft, Apple and Oracle which is significant because the first two named were part of a group of 5 companies that have built 10% of all the wealth created in the market since 1926.
Another takeaway from the paper is that the mean return of stocks is positive, but the median is negative. All the academic theory regarding risk and return categorizes assets by mean return, perhaps it is the best approximation of the probability distribution although it doesn’t tell the entire story.
Portfolio managers deal with the reality of the skew by embracing the following:
- Holding periods intended to capture a period of outperformance in the stock
- Concentrating portfolio holdings
- Generating the myth of black swans
Their mistakes can be summarized as follows:
- Extrapolating above trendline growth into the future
- Misunderstanding the mission of stock selection
- Mistaking economic change for cyclicality
Let’s examine the actions and mistakes of portfolio managers.
Holding periods intended to capture a period of outperformance in the stock.
Often exalted as the greater fool theory, this strategy basically is a game of hot potato. The portfolio manager believes that she can utilize current data points to ride a stock through a quarter or more of better than expected earnings and create alpha. In our 30 years in the business, we have seen this strategy become harder and harder because data has been commoditized. Once upon a time there was value to sitting down with the CFO and reviewing quarterly trends to evaluate the company’s short-term prospects. The information arbitrage has been disappearing due to regulation and a democratization of information access.
Concentrated portfolio holdings.
The only way to beat the market is to be different from it is an old expression in portfolio management. However, the portfolio needs to be different and populated by stocks outperforming in the short run. A concentrated portfolio that is outperforming has a skew of its own because unless it is industry specific, the portfolio will represent underperforming and overperforming stocks. The outperformance will come from two or three stocks because of stock specific revaluation or just representatives in a hot sector. The compounding effect of winners allows concentrated portfolios to outperform over a long holding period measured in decades. The skewed performance of a Microsoft or a Berkshire Hathaway can deliver significant wealth creation to a 10-15 stock portfolio held for multiple decades. The issue is that a concentrated portfolio does not have the compounding effect in any short period of time and is more volatile than the market. Utilizing a concentrated buy and hold strategy is fine for an individual not willing to fire himself but it is a brutal business strategy for investment professionals.
Generating the myth of black swans.
When portfolio managers underestimate the volatility of a stock (despite 4-digit accuracy available to them daily), black swans are the culprit. As we wrote in When Grey Swans Cry, it is the implied volatility expressing itself. Grey swans are the normal risks in a stock that should be known to a portfolio manager while black swans are unknowable in advance and thus the scapegoat. When companies destined for history’s dustbin end up there, the cries of rare and implausible are written in the investor’s yearly report.
The above deals with portfolio construction, the next step is to look at stock selection.
Extrapolating above trendline growth into the future.
Bessembinder’s study revealed that only 47.7% of stocks beat 1-month Treasury bills while remaining a public company. It appears capitalism is designed as a mechanism consisting of the odds of a coin toss in order to add value over the risk-free rate. That is not the premise of financial analysts determining the valuation metrics of a stock. Financial analysis starts with the thesis that the stock has value into perpetuity. Finance 101 basically rules out the dynamic nature of capitalism, this is the equivalent of physicists ruling out gravity. A case can be made that cash flow after 20 years are inconsequential to a discounted cash flow outcome, but there are problems with that argument. First, if the business were to disappear at the 20th anniversary of the model, the cash flows would be tailing off much sooner than the model. Second, in three years the model would have to begin to truncate the cash flows at 17 years then 15 years and so on. This would reduce the multiple paid three to five years out, thus the investment would have a smaller exit multiple with the investor not even receiving credit for the growth.
Misunderstanding the mission of stock selection.
In order to add alpha in stock selection a portfolio manager must arbitrage information or time. This is the simple outcome of any investment thesis that states: we believe the stock is undervalued because of fill in the blank and the market will realize it a fill in the blank time frame. Professional investors play a very short-term game in order to protect their job. Keynes’ observation that in the long term we are all dead rings true in the mind of the portfolio manager. 5 stocks have created 10% of all the wealth but each of the companies went through a prolonged price slump versus the market. It becomes impossible for portfolio managers to ride out these periods. It is impractical to know if an investor is worthwhile unless a time period exceeding 20 years is used. This is primary reason that the investment business is run in a chaotic manner, in a sea of quantitative analysis only the error term is observed for a long period of time.
Mistaking economic change for cyclicality.
Capitalism begets disruption which then changes capitalism until disruption begins again. Investors are taught to believe in cyclic changes rather than discontinuous changes. This is the natural extension of the belief that the company will exist into perpetuity. If a company is permanent than only cyclical downturns should occur rather than death blows. However, this is exactly the point of the Bessembinder study, individual stocks are much riskier than we want to believe. Suggesting that disruptive competitors will only get the customers searching for value decimated the traditional auto, print media and phone industries in the United States.
Nothing succeeds like success, unless we are unable to define success because of our blind spots. The skew of stock returns is an uncomfortable reality for professional investors. It need not be.