Three Common Stock Market Misconceptions
The stock market is one of the most widely discussed subjects in the world, and with such discussions, a multitude of misconceptions have emerged. This article aims to address three of these misconceptions, specifically focusing on the following three:
- Active investing yields better returns than passive investing.
- You need a lot of money to start investing.
- Stock market returns are normally distributed.
This article is not financial advice, as always do your own research before investing or any other financial decisions.
Active investing yields better returns than passive investing
One of the most common misconceptions is the belief that active investing outperforms passive investing. This misconception often originates from the intuitive idea that increased activity always enhances performance. However, in the world of investing, the opposite often holds true. In many cases, timing the market, or hopping in and out, has significant impact on the final results of the investment. See the figure below from this article, which shows that even missing the 10 best days, in 29 years, yields to a total return that is 54% smaller than that of a passive, disciplined strategy. Notably, these highly profitable days often materialize unexpectedly, sometimes following extended periods of lackluster returns within a bear market, a period when many emotionally-driven investors have already exited the market. Consequently, maintaining a steady investment approach, especially during challenging times, can be pivotal to achieving substantially superior returns. Hence, passive investing frequently emerges as the more prudent choice, although it may demand a resilient and unwavering commitment.
These findings are not only found among individual investors; institutional investors also frequently find themselves underperforming market indices when pursuing active investment strategies. However, it's important to note that institutions often prioritize transaction costs and commissions over the pursuit of outperformance. Staying in close alignment with the benchmark or slightly underperforming it is deemed a lower-risk approach, with the primary objective being to retain as much capital under management as possible.
The table provided below offers a compelling illustration of this phenomenon. In the short term, around 60 to 70 percent of funds fail to outperform their respective benchmarks, while over an extended time horizon, even a smaller percentage of funds successfully surpass these benchmarks. For small cap stocks this is even as low as 3.27% over a 15-year time horizon.
Consequently, achieving consistent outperformance relative to the benchmark through active management proves to be an incredible challenge. While consecutive periods of outperformance over the long term can yield substantial rewards, doing so demands an extensive repertoire of market knowledge, talent, and unwavering discipline. Therefore, passive management often emerges as the superior choice for those with limited time or lack of knowledge on active strategies. The pursuit of active management seems attractive due to the high pay-off. However, this is only for those with a dedication to learning, adaptability, and the accumulation of knowledge.
Stock market returns are normally distributed
It is often mentioned or assumed that stock market returns follow a normal distribution, however, every mathematician or statistician will argue otherwise. When one examines the historical returns of the S&P 500 since 1871, as highlighted in this article authored by Joachim Klement, it becomes notable that the tails of returns are much fatter. This skew towards the tails is not immediately apparent, and on initial inspection, the data may seem to conform to a normal distribution. However, making calculations based on this assumption can lead to critical errors and inaccuracies.
A normal distribution will look like the figure below, with 99.7% of the data within 3 standard deviations.
If returns were normally distributed, jumps greater than five standard deviations would be exceedingly rare, occurring roughly once every seven thousand years in daily price data. However, in reality, such significant jumps tend to happen about once every three to four years. This discrepancy serves as a great contradiction against the assumption that stock market returns adhere to a normal distribution.
So, if stock market returns are not normally distributed, what is their distribution? Renowned American economist Eugene Fama, based upon the work of the famous mathematician Mandelbrot, posited that stock market returns follow a stable Paretian distribution characterized by an exponent alpha that is less than 2.
Furthermore, in the book "The (Mis)Behavior of Markets," co-authored by Mandelbrot and Richard Hudson, an important concept known as "clustering" is introduced. This concept resembles the Pareto principle, which states that a substantial majority (80%) of effects stem from a relatively small portion (20%) of causes. Clustering is observable in stock market volatility as well, with periods of high volatility clustering together, as do periods of low volatility. While the insights of this phenomenon are not discussed in detail here, it is a significant aspect of stock market behavior.
From an economic perspective, this all makes perfect sense. Volatile days tend to trigger panic and emotional responses in the markets, fueling even more volatility. Conversely, periods of low volatility tend to induce relative stability. Various other distribution models, such as the student-t and Laplace distributions, have also been proposed to better capture stock market returns' behaviors and deliver improved results.
Thus, there are multiple distributions that represent the returns much better than a normal distribution, this should always be taken into account when conducting research.
You need a lot of money to start investing
Another common misconception revolves around the belief that substantial wealth is needed to start investing. However, the mindset of "I need to be rich to start", must switch to "I must start to become rich." The power to achieve this, is called “compounding”, a truly magical force, capable of transforming even modest monthly contributions into substantial wealth over an extended period.
To provide some perspective, consider the historical performance of the S&P 500, which has yielded an average return of 10.15% since its inception with 500 stocks in 1957. Over a span of 60 years, investing $100 each month would amass a total of $5,074,990.07. Remarkably, the total contributions made over this period would amount to just $72,000, significantly less than the final wealth accumulation. Even if the monthly contribution were reduced to $50, the end result would still be an impressive $2,537,495.03. Hence, even with lower monthly investments and accounting for inflation (S&P 500 return of approximately 7%), these outcomes are remarkable when compared to the initial capital invested ($556,093.13).
The power of compounding isn't limited to everyday investors; it is a principle that even the greatest financial minds, like Warren Buffett, have harnessed for their success. Warren Buffett's journey serves as a compelling illustration of the impact of compounding. Starting his investment journey at the young age of 11, Buffet managed to accumulate a stunning $112.9 billion (age 93). By the age of 50, Buffett had amassed “just” $300 million. Thus, Buffet accumulated 99.73% of his net worth in 50% of the total time. This truly shows the power of compounding.
Buffet of course achieved a much higher annual percentage return of 19.8%, yet it still shows that compounding can be truly magnificent. You may not end up on the Forbes list of billionaires, but it will give great odds for achieving a nice retirement sum. However, always keep in mind that these are averages, there might be rolling periods that produce much lower returns, which can be seen in the table below from the book “What Works On Wall Street” by James O’Shaughnessy. Here over a 10-year period, the lowest possible return is -4.95%.
But as always, over the very long term these results average out, where there is no rolling period from 1973 to 2009 of 15 years that yielded negative returns in total. As stated by Dana Anspach: “If you were a long-term investor, the worst twenty years delivered a return of 6.4% a year, which occurred over the twenty years ending in May 1979.”. See the article here.
Therefore, it is very important to invest only as much as you can afford to lose, as there can be very long periods of little to even negative returns. Being able to sit through these times will lead to very great returns, but these are only for the most disciplined and patient investors.
Final Word
These three misconceptions were covered very briefly, the articles and books mentioned dive much deeper into these concepts. Nevertheless, the goal of this article is to bring light to these misconceptions.
There are numerous other financial misconceptions that can be covered, but those will be subjects for future discussions. As always, please do not hesitate to reach out for further discussions on financial topics or to share ideas for future articles. Thank you for reading and engaging in this discussion!