From academia comes a study that suggests that simply buying a market index does not live up to reasonable return expectations, even over a long period of time. (The study is summarized here by CXO Advisory. You can access the full paper here.) S&P 500 constituents were measured from 1991-2010 by sampling the members in 2004 and 2010. The reasonable return expectation was set up by the authors using the 10-year Treasury bond yield, plus a risk premium of 4.0% to 4.7%. This is a standard way that long-term returns are estimated in academic finance, by the way. (Back in the olden days, when people thought stocks were actually risky, a risk premium of 6% was the rule of thumb.) So how did stocks actually measure up during that 20-year period? According to CXO Advisory:
Even though the aggregate market value of S&P 500 components grows from $2.8 trillion in 1991 to $11.4 trillion in 2010, these firms underperform reasonable investor rate of return requirements (T-note yield plus a modest equity risk premium) by $4.5 trillion.
Even using a pedestrian risk premium, blue chip stocks-in aggregate-did not compensate you very well for the risk. The authors also point out in the abstract that:
41% of the companies included in the S&P 500 in 2004 or 2010 created value in 1993-2010 for their shareholders, while 59% destroyed value.
Even over a 17-year holding period, the majority of companies destroyed shareholder value. Keep in mind that these were not fly-by-night outfits, but the bulk of the largest public firms in America. Even buying blue chip companies over the long run is likely to cause you to lose your shirt. Buy and hope, unless you get lucky, is not going to work.
Should you give up on stocks entirely and hide your money under the mattress? We think not. After all, 41% of the stocks created shareholder value—and some of them did exceptionally well. The stocks that created the most shareholder value were the ones that went up the most in price. If we focus our attention on those stocks with the most powerfully rising prices, we can identify the companies that created the most shareholder value. Hmmm…come to think of it, that’s the basic definition of relative strength.
In contrast to buy-and-hope (internally we sometimes refer to this investment solution as sit-and-take-it), systematic application of the relative strength return factor has been shown to add a lot of value to the investment process.
