The investment strategists at JP Morgan like their symmetry.
They released their first research report on stock concentration risk in 2004. Wrote another in 2014 and then planned to write another in 2024. In other words, each report was to be released an exact decade apart.
Then 2020 happened.
The year-like-no-other prompted JP Morgan to move up their timeline and they recently released their latest update—roughly four years ahead of schedule. But this release has a symmetry of its own as it now captures a perfect 40 years of market data.
I’ve highlighted the results of JP Morgan’s previous 2014 stock-concentration research before, and as a reminder, the results weren’t pretty. Examining the universe of Russell 3000 companies since 1980, JP Morgan found that roughly 40% of all stocks suffered a catastrophic loss. What defines a catastrophic loss you ask? A catastrophic loss equates to a permanent 70%+ decline from the stock’s peak value. So these losses are not only ugly, but there’s also no recovery.
Think Trump Hotels & Casino Resorts, Blockbuster or Bear Stearns.
Now, if you had to guess, would you say that the 40% catastrophic-loss figure has improved or worsened with the addition of six more years of data? Right. It’s worse. In fact, it’s significantly worse across virtually all sectors:
The odds of any given stock blowing up were always high, but the odds have worsened
Source: JP Morgan, Turner Investments. Based on Russell3000 Index data. A catastrophic loss is a permanent decline of 70% or more.
So why would you invest in equities at all given this high probability of catastrophic failure? Because a small number of ‘mega-winners’ actually carry the day for the broader Russell 3000 Index and result in its overall positive gains (roughly 15% annualized returns over the past decade, for example).
Gains being powered disproportionately by a small number of stocks is, in fact, true for most major indices. In the case of the Russell 3000, these mega-winners only comprise about 10% of the Index. In fact, the MEDIAN stock in the Russell 3000 has actually recorded a NEGATIVE return over the long term and JP Morgan further highlights that “around 2/3 of the time, a concentrated position in a single stock would have underperformed a diversified position in the Russell 3000 Index.” So, unless you own a broad-based equity ETF, your odds of owning a sufficient number of these mega-winners to keep pace with or outperform the Index are low.
Yet investors always believe that they can pick the best-performing stocks and often fail to recognize the need to diversify. Recall the research of Brad Barber and Terrance Odean. Mr. Barber and Mr. Odean were researchers at the University of California who conducted a landmark study of investor behaviour during the 1990s. They looked at the holdings and trading activity of roughly 78,000 households at a large US discount brokerage over a multi-year period.
One of the more remarkable revelations of their study was that the mean household only held 4.3 stocks. That’s it. If you combine this lack of diversification with the catastrophic-loss probabilities outlined by JP Morgan then the investing danger becomes obvious.
But all of this, I should point out, is an argument against concentration risk not an argument against equity-market exposure itself. There are the naïve, under-diversified stock-pickers who believe they’ll magically avoid the catastrophic losses, but then there are those at the opposite end of the spectrum who believe that equity markets should be avoided entirely. Fear of higher interest rates or the US Federal Reserve tapering its asset purchases being just the latest excuses to avoid equities.
When we last worried about the Fed tapering its asset purchases, back in May 2013, the market concern lasted about a minute. The S&P 500 sat at the 1,650 level then. Now it’s at more than 4,250, almost a three-fold advance. And the last time we had a Fed tightening cycle—nine interest rate hikes from late 2015 to mid-2019—the S&P 500 advanced 57% on a total-return basis.
And in case you’ve forgotten, equity markets have survived much worse than higher interest rates and an easing of Fed stimulus. There was a time when the worst global pandemic in a century swept across the world killing millions, shuttered the world’s largest economy to the extent that its Q2 GDP actually dropped 33% on an annualized basis, its worst plunge in about 75 years, and resulted, of course, in the onset of the fastest bear market in the S&P 500’s history.
And yet the S&P 500 still advanced more than 18% for the year…which is to say, last year.
Tell me again about your excuses for not investing in equities this time around?
Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.
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