Many of you reading this short note will have, at some time, travelled down to Devon for a lovely summer break amongst the rolling fields, moors and beautiful beaches of this somewhat remote county.  

Only a few will have ventured into Plymouth, the famous naval seaport and home to Sir Francis Drake (that famous Elizabethan pirate who so vexed our Spanish friends by stealing their gold) and the site of the departure of the Mayflower with the pilgrims on board heading to America 400 years ago. Even fewer will know that it was the place of an amazing insight into the powerful nature of crowds, which provides us with a wonderful world picture of how markets operate.

In 1906 a Victorian gentleman named Sir Francis Galton attended a livestock fair aptly named The West of England Fat Stock and Poultry Exhibition in Plymouth. One of the many attractions at the fair was a guess the weight of the ‘dressed’ ox on display (similar to the game of guessing how many cookies are in the glass jar). The competition attracted 800 people all paying 6d (half a shilling) to write down their guess, name and address on the back of the ticket. The nearest guess to the actual weight would win a prize. The fair, as you can imagine, attracted many sorts, from the general public (old and young) to farmers and butchers.  

Being a statistician, amongst many other things, Galton bought the used tickets off the stall holder. Of the 800, 787 were usable. Back home he analysed the guesses and published his finding in Nature, March 7, 1917 in an article titled ‘Vox Populi’. His remarkable finding is illustrated below.  

Figure 1: Guessing the weight of the ox – the ‘crowd’ got it more-or-less spot on.

Source: Albion Strategic Consulting

The range of guesses was wide (-133 lbs. below the average to +86 lbs. above it), the participants were varied, and the numbers involved were quite large. The ‘crowd’ in aggregate showed ‘wisdom’ compared to its individual participants.

This story provides a great insight into how modern financial markets work. The markets are made up of many players, from individual DIY investors, day traders, stockbrokers, hedge funds, fund managers, sovereign wealth funds, endowments and other institutional investors. Each investor holds their own view on the future prospects for a specific security, such as the price of BP or Apple shares. Some will like a stock and others not. They cannot both be right.  

The market – given all the information available to it – settles on an equilibrium price for every stock. This price will move, sometimes dramatically, as we have seen recently as the ‘market’ reaches a new equilibrium price, given the new information that it has collectively processed.

At times like these, some investors are prone to running ‘what if’ scenarios in their heads such as: ‘if companies are in trouble because their revenues have been cut off, then they will renege on their property lease terms and the landlords will suffer.  It seems likely that things will get worse over the coming weeks. If property landlords are in trouble that might lead to problems in the banking sector’. It all sounds plausible. They may then be tempted to sell out of property or banks or even equities altogether. The crucial mistake is that they forget that they are not the only person to have thought this through and these very sentiments and views are already reflected in the current price of listed commercial property companies, bank stocks and the markets in general.  

Markets will move again – down or up – based on the release of new information, which in itself is random. Second guessing random events is futile. You may make a guess and be lucky but that is speculating not investing. Accepting the ‘wisdom’ of the market helps us to challenge ourselves as to whether we really have superior insight relative to everyone else. It seems unlikely. As Charles Ellis, the wise sage of investing from the US, states:

‘In investing, activity is almost always in surplus’.

Activity based on guessing – particularly when it relates to shorter-term issues that sit well within your true investment horizon – is best avoided.

Next time you pass Plymouth on the A38, reflect on one of its great historical events, The West of England Fat Stock and Poultry Exhibition of 1906. 

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Risk warnings:

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed. 

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Errors and omissions excepted.

In a recent research paper entitled 'How to increase the odds of owning the few stocks that drive returns', global asset manager Vanguard revealed a telling statistic. Between 1987 and 2017 just under half of the 3 000 largest stocks listed in the US delivered a negative return.

Over this 31 year period, 47.4% of companies in the Russell 3000 Index saw their share prices decline. Some of those went bankrupt, delivering a negative 100% return.

What's more, the return of the median stock over these three decades was just 7%. In other words, if you picked the average stock, your return was insignificant.

This was over a period when the total return from the Russell 3000 Index was 2 100%. As the chart below illustrates, this performance was driven entirely by just 7.3% of stocks that returned over 1 000%.

Source: Vanguard, Wealth Logic LLC

Needles in the haystack

Of course, this is something of an over-simplification. Just because a stock declined over a full 31 year period, doesn't mean that it didn't make significant gains in between.

For instance, Superdry's share price may be 80% down from its 2018 peak, but an investor who bought the stock in mid-2012 and sold out of it before it collapsed could still have earned a return of 700% or more. It was, therefore, still possible to make a big return, even though Superdry's performance since listing is ultimately negative.

However, the broad lesson holds: there is an extremely small pool of persistent winners in the stock market. An investor picking a share at random is far more likely to under-perform the market over the long term than to out-perform it, and has almost a 50% chance of losing money.

This illustrates how difficult it is to be a successful stock picker. There are very few companies that are going to deliver a long term out-performance. It may be possible to beat the market through buying and selling stocks like Superdry at the right time, but that comes with additional risk. If you get it wrong, the consequences can be severe.

Fewer needles, more haystack

Research from the National Bureau of Economic Research (NBER) in the USA also suggests that not only are the 'winning' companies rare, but they are becoming even more so. A 2016 paper entitled 'Is the U.S, public corporation in trouble?' found that, on average, listed companies in the US have become larger, but they have also become less profitable.

Profitability is one of the key factors in share price returns, as investors are effectively buying a share of the company's future earnings. The higher those earnings are likely to be, the more investors will be willing to pay.

What the NBER found, however, is that the profitability of the market as a whole is being driven by a smaller and smaller concentration of companies.

“Over the last 40 years, there has been a dramatic increase in the concentration of the profits and assets of US firms,” the NBER authors note. “In 1975, 50% of the total earnings of public firms is earned by the 109 top earning firms; by 2015, the top 30 firms earn 50% of the total earnings of the U.S. public firms. Even more striking … we find that the earnings of the top 200 firms by earnings exceed the earnings of all listed firms combined in 2015, which means that the combined earnings of the firms not in the top 200 are negative.”

The growing concentration of not just earnings, but many measures of corporate strength among listed companies is illustrated in the table below:

Source: National Bureau of Economic Research

Compare this against the table below, which shows how, on average, profitability has fallen significantly over this 40 year period:

Source: National Bureau of Economic Research

What are your chances?

“Though performance has worsened for the average firm, the winners have done very well,” the study points out. “One way to see this is that four new firms entered the list of the top five firms by market capitalization in 2015, relative to 1995. Specifically, Apple, Google, Microsoft, and Amazon replace AT&T, Coca Cola, General Electric, and Merck. In 2015, these four firms combined had earnings of $82.3 billion, representing 10 percent of the earnings of all public firms combined.”

This shows just how small the pool of 'winning' stocks has become. Successfully identifying them beforehand would be extremely profitable, but it is also becoming more and more difficult to do.

Photo by Chris Liverani on Unsplash

What will happen in the global financial markets tomorrow, next week or over the coming month?  It’s tempting to speculate, isn’t it? Indeed, speculation about the short-term direction of shares, bonds, currencies and commodities represents a good chunk of the output of the financial media every day.

To be fair, people have a natural curiosity about the future, particularly when their is money at risk. This makes it understandable that the media would seek to satisfy that need in its coverage.

Markets are inherently uncertain

The problem is financial markets are inherently uncertain. Prices move randomly in the short term and there is little to be gained for investors by trying to second-guess them.

This point is easier to understand if you reflect on the fact that what moves prices is news. It might be an earnings report involving an individual company, a regulatory ruling affecting an industry, a data release relating to an entire economy or a geopolitical development that affects the whole world. 

Prices are always changing as new information comes into the market. And the biggest changes in prices tend to occur on the news that no-one expected. For example, opinion polls might suggest a certain political party is certain to win a major election. Markets will price for that eventuality. But if there is an upset, prices will adjust very quickly.

An impossible task

What this means is that successfully speculating on short-term movements in security prices with any consistency requires an ability to accurately forecast the news. We’re not sure about you, but we’ve yet to meet such a person.

But it’s even harder than that! Even if you could forecast the outcome of news events — say a G7 statement or an interest rate change or a merger — you still need to be able to forecast how the market will react.

Now that’s especially tough because what moves prices is the degree to which the news lines up with what’s priced in. You might get a weak employment figure, for instance, but the share market might still rally if the headline figure is not outside the bounds of expectations.

The fiendish difficulty of forecasting markets is also partly because set-piece events that dominate media attention do not tend to occur in isolation. A big economic announcement might have been expected all week, but what if it is overshadowed on the day by a development in the Middle East that upends the oil market and drives equity prices lower?

We look for tidy narratives

In fairness, we doubt the media will ever give up on constructing speculative “stories” about markets by linking fundamental news about the economy or earnings to price changes. It fills a niche and there’s a real appetite among the public for tidy narratives that link cause and effect.

But for the individual investor it is best to distinguish between the daily noise of news and security price movements from the long-term signal of capital market returns. The latter are more predictable.

We know that over time, there is a return on investment. If capital markets did not ultimately reward investors, there would be no appeal in investment!

But the returns are not there every day, every week or even every year. Timing them is tough. What’s more, we don’t need know which individual asset classes, markets or securities will deliver the strongest returns next.

Like a patchwork quilt

This is best illustrated by the Periodic Table of Investment Returns, from Callan Associates in California. This shows the annual returns for various asset classes over 20 years, defined by indexes and grouped by colour.

Each column illustrates the returns for each year. Those with the biggest returns are at the top and those with the lowest are at the bottom. It looks like a patchwork quilt, doesn’t it? In fact, it’s hard to see any pattern at all.

Sometimes, emerging markets will top the table. Other years, it will be cash or bonds or real estate. The long-term premiums from these assets are available, but they are not evenly distributed.

Diversification is key

That means to succeed as a long-term investor, you need to take a bigger picture view, focusing firstly on how you allocate your capital across different asset classes like stocks, bonds, property and cash and secondly on ensuring you are diversified within these asset classes.

By having a little bit of all those asset classes, you are guaranteed to reap the returns when they do kick in and you don’t have to worry about market timing.

Finally, success over the long-term requires discipline and sticking to the plan that is made for you, attending to what you can control (asset allocation, diversification, cost, taxes and rebalancing) and ignoring as much as you can the daily noise that preoccupies the media.

By the way, this doesn’t mean you shouldn’t take an interest in the news. We all want to know what’s going on in the world after all. But it’s a caution against using daily news headlines to drive your investment strategy. 

Prices, like news, are simply unpredictable.

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