Episode 346 - Hendrik Bessembinder: Why It's So Hard to Beat the Market

Episode Summary

Executive Summary: Benjamin Felix and Mark McGrath interview Hendrik Bessembinder about skewness in long-run stock and fund returns. The core lesson: a small minority of stocks and funds create most wealth, so mean returns are misleading for typical outcomes. They discuss diversification, active management, global evidence, and planning implications, emphasizing that investors should think in distributions, not averages.

Main Topics: Positive skewness in stock returns (Priority: 5/5): Bessembinder explains that a few extreme winners pull up average returns, making the mean unrepresentative of what most stocks actually deliver over long horizons. Do Stocks Outperform Treasury Bills? and its surprise factor (Priority: 5/5): The 2018 paper was striking not because skewness was unknown, but because its magnitude over long compounding horizons was much larger than many expected. Diversification vs concentrated bets (Priority: 5/5): The conversation explores how skewness strengthens the case for broad diversification, while still leaving room for skilled managers or investors who deliberately seek upside asymmetry. Wealth creation is concentrated in a few stocks (Priority: 5/5): Bessembinder distinguishes return statistics from dollar wealth creation and shows that a tiny fraction of firms accounted for essentially all net wealth creation in U.S. markets. Mutual fund performance, fees, and skewness (Priority: 4/5): The same long-run skewness pattern appears in mutual funds: many underperform, some outperform dramatically, and investor behavior plus fees worsen outcomes. Practical applications for financial planning (Priority: 4/5): He argues planners should move beyond mean returns and use full distributions or simulations, with medians often more informative than means for long-horizon planning. Broader research and the 'sustainable return' concept (Priority: 3/5): Bessembinder briefly discusses other work in market microstructure, electricity markets, and a new measure of return focused on sustainable withdrawals rather than terminal wealth.

Key Arguments: Positive skewness means a few very large outcomes pull the mean above the median, so the average stock return is not what a typical stock experiences. The surprise in his 2018 paper was the magnitude of long-run skewness, not the basic existence of skewness. Short-run volatility is the main mechanical source of long-run skewness; more volatility produces more skewness after compounding. Individual stock outcomes are extremely unfavorable for stock pickers: most stocks underperform broad benchmarks over long horizons. Broad diversification is still highly valuable because it reduces idiosyncratic risk and keeps investors from relying on a small chance of owning the rare winner. Some investors may rationally prefer skewness, either because they believe they have skill or because they enjoy lottery-like upside. The same skewness logic applies to mutual funds: many funds underperform even before fees, but a small subset delivers very large outperformance. Fees matter, but so does return-chasing behavior; both help explain why mutual fund investors lag benchmarks. For planning, investors should not rely only on a single expected-return input; simulations and full outcome distributions are more informative. A new 'sustainable return' framework may be more useful than terminal wealth for retirement, endowment, and spending decisions because it focuses on what can be withdrawn without depleting capital.

Data Points: Stocks beating Treasury bills: About 42% - Lifetime buy-and-hold returns of individual U.S. stocks exceeded one-month Treasury bills. Stocks beating the market: About 31% - Lifetime buy-and-hold returns exceeded the overall market return. Negative absolute returns: Slightly more than 50% - More than half of stocks delivered negative buy-and-hold returns over their lifetimes. Total-loss stocks: About 11% - Stocks losing 98% or more of capital (effectively total losses) in the U.S. sample. Single-stock bootstrap vs T-bills: About 27% - Simulated random single-stock strategies beat Treasury bills over the 90-year horizon. Single-stock bootstrap vs market: 4% - Random single-stock strategies beat the market over the full 90-year horizon. 100-stock bootstrap vs market: 43% - Randomly selected 100-stock portfolios beat the market over the full 90-year horizon. Net wealth creation explained by firms: 4% of stocks - A tiny share of U.S. firms explained all net wealth creation since 1926. Stocks reducing shareholder wealth: About 57% - Roughly 57% of stocks reduced shareholder wealth in dollar terms. Mutual funds beating SPY: 30% - U.S. equity mutual funds in the sample beat the SPY benchmark over the study horizon. Funds that doubled SPY: About 450 funds - Out of nearly 8,000 mutual funds, this many doubled the SPY over their lifetimes. Funds that tripled SPY: About 160 funds - Out of nearly 8,000 mutual funds, this many tripled the SPY over their lifetimes. Skewness effect in mutual funds: 12 basis points per month - Estimated performance uplift needed to make half the funds beat SPY, attributed to skewness effect. Average mutual fund fees: 9 basis points per month - Average fee level in the fund sample used in the study. Fund investor underperformance: $1 trillion - Estimated underperformance of mutual fund investors versus SPY, incorporating fees, opportunity costs, and return chasing. Median stock time in database: 7-8 years - Stocks typically do not remain in the database long, motivating bootstrap simulations. Highest lifetime stock return: Altria Group ~250 million% - Top lifetime compound return in the U.S. sample over the full multi-decade horizon. Global stock sample length: 30 years - Global study had a shorter sample than the U.S. study but found similar or stronger skewness.

Pivotal Quotes: "The mean will be higher than the median, which is half or above and half or below." — Hendrik Bessembinder: Explaining positive skewness and why average returns can misrepresent typical outcomes. "The only way to be sure of having tomorrow's big winners in your portfolio is to own all the stocks." — Hendrik Bessembinder: Discussing diversification and the odds of capturing rare extreme winners. "Don't focus entirely on the means. Give thought to the fact that there will be skewness in long-run outcomes and that most likely you'll be below the mean." — Hendrik Bessembinder: Summarizing the main financial-planning implication of his research.

Implications: Investors and planners should use full return distributions, not just expected returns. Broad diversification remains the default for most people, while active or concentrated bets require real skill, strong conviction, or a deliberate appetite for skewness.