Interesting stats from The Irrelevant Investor:
A study from J.P. Morgan examines all Russell 3000 stocks from 1980-2014. What they found was that 40% of all stocks suffered a catastrophic loss, which they define as “a decline of 70% or more in the price of a stock from its peak, after which there was little recovery such that the eventual loss from the peak is 60% or more.” J.P. Morgan also found that two-thirds of all stocks underperformed the Russell 3000, while 40% of stocks experienced negative absolute returns.
Active management, which seeks to add value over a cap-weighted index, has its work cut out for it. Some investors will simply look at the 7.57% annualized return of the Russell 3000 index from 1990-2014 (I didn’t have access to Russell 3,000 data going back to 1980) and conclude that they are just fine investing in a fund that seeks to track the returns of this capitalization-weighted index. I would argue that such an approach would be more prudent than simply buying 25 individual stocks in 1980 and holding them through 2014. At least with a fund that seeks to track the Russell 3,000 Index you get a more diversified approach that will give the most weight to the largest cap stocks. However, a cap-weighted index does suffer from the vulnerability of having significant exposure to large cap stocks that turn south and embark on extended periods of underperformance (think Japan in 1989, or tech-heavy Nasdaq in 2000).
Where a relative strength strategy excels is in focusing on those stocks within a broad investment universe that are demonstrating the best price momentum. The best price performance may or may not be coming from the stocks with the largest capitalization in the Russell 3,000. Furthermore, what you don’t own is every bit as important as what you do own. Presumably, many of those stocks from the J.P. Morgan study that experienced negative absolute returns or trailed the Russell 3,000 Index had weak price momentum for long enough periods not to spend too much time in a Momentum-driven portfolio strategy.
For those investors looking to dig deeper into the merits of a momentum approach to investing, I would recommend reading Relative Strength and Portfolio Management by John Lewis or some of the other research we have posted on our site.
Source of returns for the Russell 3000: FactSet. Total returns inclusive of dividends, but does not include transaction costs or management fees. The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value.
HT: Abnormal Returns