Eric Crittenden has recently updated his research on the distribution of stock returns over time—research that underscores the rationale for trend following strategies. His study now covers the period 1989-2015. See below for further explanation:
Longboard’s original research proves that over the long term, a small minority of stocks drive returns for the overall market.
If you’ve heard of the Pareto Principle before, this might not surprise you.
What does this mean for investors? It may be more efficient to navigate this reality by getting defensive, and strategically avoiding the majority in this equation: the underperforming investments.
Be aware of disproportionate rewards
Here’s a closer look at our research on this competition gap in action in the U.S. stock market.
We analyzed 14,455 active stocks between 1989 and 2015, identifying the best performing stocks on both an annualized return and total return basis.
Looking at total returns of individual stocks, 1,120 stocks (7.7% of all active stocks) outperformed the S&P 500 Index by at least 500% during their lifetimes. Likewise, 976 stocks (6.8% of all active stocks) lagged the S&P 500 by at least 500%. The remaining 12,404 stocks performed above, at or below the same level as the S&P 500.
The principle of the competition gap remains true in practice: The minority accumulates a disproportionate amount of the total rewards, creating a “fat tail” distribution of extreme outperformers and underperformers with a large gap between the two.
Focus on the minority
What’s more, the left tail in the stock market’s competition gap (or distribution) is significant. 3,431 stocks (23.7% of all) dramatically underperformed the S&P 500 by 200% or more during their lifetimes.
So, let’s say an investor’s portfolio missed the 20% most profitable stocks between 1989 and 2015. Instead, he invested in only the other 80%. His total gain would have been 0%.
Once again, the principle holds true: Over the long term, the more efficient approach is to strategically avoid the many underperformers.
Seek alternative long-term returns
To get more benefits from alternative allocations, investors can seek long-term trend following strategies that proactively trim investments that don’t perform over time. These more defensive strategies are better positioned to avoid sustained downtrends — and a diversified portfolio with fewer strategies trapped in sustained downtrends can recover more quickly.
What’s more, some of the same strategies that can deliver this downside protection can add further diversification, potentially delivering results that are uncorrelated to the market and to other alternatives.
If ever there was a need to highlight the need for relative strength analysis, this is it! It is no small thing to have a discipline for weeding out underperforming stocks from the portfolio and Dorsey Wright is uniquely positioned to help you with this task. Subscribers of our research can use our technical attribute ratings and our matrix tools to weed out weak stocks. Users of our investment products can access strategies that have defined sell disciplines in place. The sell discipline will differ by strategy, but it is there for each of them.
Sitting on losing positions with the belief that they will eventually turn around is a fool’s errand. But isn’t patience the key to long-term investment success? Yes and no. Patience in a well-designed investment strategy is one thing. Patience in losing positions is another thing entirely. Individual stocks are under no obligation to provide a profitable experience for their investors. Stocks don’t know when or at what price you bought them. As the research above demonstrates, many–in fact most–stocks are losers relative to a broad market benchmark. It is up to you to successfully navigate the very fat-tailed distribution of stock returns. Relative strength can help.
Click here for disclosures. The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value.