This is a two part series on uncertainty and luck in the stock market. Read part one here! (On hindsight, this post should have been part one. But we live and learn.)
In part one, I used an example of one of my stocks shooting up after I bought it. Guess what? A few days after that post, another of my ‘undervalued’ stock shot up! This leaves one more ‘undervalued’ stock that has yet to move anywhere. Maybe this post will do it.
Part 2 covers some statistics on stock market returns. Don’t worry, not much math here.
We Hardly Get ‘Average’ Returns
We often hear statistics like ‘The average return of the STI over a long period is 7% per year’ or ‘This fund has outperformed the index benchmark by 5% per year since inception’
These statements are true, but the reality is often different. Take a look at annual returns of the S&P500 (dividends reinvested). Data from here
The average return is 9.99% per year, but take a look at the orange line. How often did the index return exactly 10%? Or anywhere close to 10%? Here’s a histogram of the returns
Only 17 out of 93 of the years had a return within 5% of the average. Roughly 20% or once every five years! We don’t see anything close to average most of the time.
We have to take this into account whenever evaluating the performance of volatile investments like equities. Even the S&P500, a basket of 500 stocks, exhibit so much volatility.
Whenever we look at our own portfolio performance at the end of the year, we have to remember that even if we over/under perform, it is most likely not the average. Taking the average over multiple years is a much better reflection of the actual portfolio performance. This is the reason why I will only evaluate my performance seriously after three to five years.
Even the Top Underperform
Does it surprise you that even the best investment managers have bad years? Here are some statistics about the performance of the top 25% of mutual funds between 2000-2009:
- 97% spent 3 of 10 years in the bottom half of performance
- 79% spent 3 or more years in the bottom quartile (bottom 25%)
- 47% spent 3 or more years in the bottom decile (bottom 10%)
Read the last line again. Roughly half of the top 25% of mutual funds spent quite some time in the bottom 10%. Bottom 10% for 3+ years!
Even famous investment managers underperform the market sometimes. Take Charles Munger, vice chairman of Berkshire Hathaway:
From 1962 to 1975, his average compounded return was 19.8% vs 5.0% (from the Dow). Even though he beat the market by almost 15% per year on average, he underperformed the market on 4 out of 13 years.
You could very well pick a top hedge fund manager. However, if you had no conviction and withdrawn your funds in the bad years, you would have missed out on the insane returns. This is why I mentioned conviction in part 1.
This underperformance also appear in individual stocks. An obvious case would be stocks with a ‘V’ shaped recovery. A sharp drop followed by a sharp rise. Those that pick their own stocks (like me) should take this into account when evaluating companies.
Remember that past performance is not an indicator of future returns. The opposite can also happen.
I started this leg of my investing journey in later half of 2018. As a result, I missed the first part of the year, which had a bad correction. This was entirely due to luck.
The element of luck is always present in investing, and learning to manage it plays a large part in determining our performance as investors. Having certain mindsets help in this regard.