Meteors

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  By Guest Blogger Doug Rowat

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A few weeks ago, after a whopping 40 drawings, some lucky individual finally won the US Powerball jackpot of almost US$700 million.

The massive jackpot had been growing steadily since early June and eventually ranked as the seventh largest lottery jackpot of all time. As MarketWatch reported, the jackpot-winner drought (thus dollar buildup) was by design: massive jackpots draw more players even if the odds don’t warrant participating. Your chances of winning that particular Powerball? About 292 million to one. Statistically, you’re actually more likely to be hit by a meteor (about 75 million to one).

More on that later.

Lottery techniques, however, have application to my industry. Big returns and huge outperformance are often promised by financial advisors leading investors to disproportionately focus on these ‘jackpots’ rather than on the long odds of actually achieving them. Sadly, our basic human nature gets exploited: people are more likely to chase a big prize they have little chance of winning as opposed to a smaller prize that’s more attainable.

People much smarter than me have studied this human tendency of ours. Collaborative research at UK and Australian universities in 2005, for instance, showed that the most effective form of incentive was one that promised a bigger prize. When given the choice of a lottery that paid off with one bottle of champagne versus one that paid off with six bottles of champagne, more chose the six-bottle payoff, even though the odds were much longer. In the end, the researchers concluded that “one big prize improves [response rates] more than many small prizes despite the lower odds of winning.” To our detriment, our mind anchors on the prize rather than the odds of achieving it.

While salesmen in the investment industry constantly brag about beating benchmarks, it’s extremely difficult to do so. I’ve frequently highlighted, for instance, the extraordinarily low percentage of active fund managers who beat their benchmarks. The latest data from SPIVA shows, as just one example, that Canadian fund managers have underperformed a blended Canada, US and international benchmark 96% (!) of the time over the past decade:

% Canadian-focused equity funds underperforming benchmark

Source: S&P Indices vs Active (SPIVA); blended benchmark: 50% S&P/TSX Composite + 25% S&P 500 (CAD) + 25% S&P EPAC LargeMidCap (CAD); data as of June 30, 2021.

It’s a shockingly poor track record. However, what I haven’t addressed in the past is WHY it’s so difficult to beat a benchmark. Certainly the high fees fund managers charge are a contributing factor, but it goes beyond this. Beating a benchmark requires consistently picking a very small percentage of outperforming stocks in an index universe. It amounts to threading a needle.

Let’s take the Russell 3000 Index as an example. The Russell 3000 is a broad-based index made up of both large-cap and small-cap US companies. JP Morgan research has noted that only a very small number of ‘mega-winners’ actually drive the performance of the Russell 3000 (which has produced roughly 16% annualized total returns over the past decade). But owning these mega-winners is tough. In the case of the Russell 3000, mega-winners over time only comprise about 10% of the Index.

And middle-of-the-road stock picks don’t favour money managers: the median Russell 3000 stock has actually underperformed the Index over the past 40 years. To meaningfully outperform, you have to hit the mega-winners, but they’re few and far between.

Think of the chart below as a ledger split down the middle at the 0% mark. Look where the blue columns are weighted: a random portfolio managers’ stock picks are, in aggregate, much more likely to fall on the negative, underperforming left side:

Distribution of excess lifetime returns on individual stocks vs Russsell 3000, 1980-2020

Source: JP Morgan

Note also the extreme ends of the distribution curve: you’re more than twice as likely to pick a total dog (-70% or worse relative performance) than a mega-winner (+70% or better relative performance).

Forbes journalist John Jennings also added to the ‘alpha’ (i.e., outperforming a benchmark) conversation last year by highlighting the difficulty of beating the other big equity index, the S&P 500. Again, the odds of outperforming are massively stacked against money managers:

…for the 20 years ended 2019, 74% of stocks in the S&P 500 under-performed the average and year-to-date in 2020 (thru 8/26), 68% have under-performed. The safest way to avoid an under-performing portfolio is to own funds that include most or all of the stocks in the index, such as index funds.

So, an advisor may come to you promising fantastic returns and spectacular alpha, but this is the equivalent of the Powerball prize. In other words, you’re being manipulated. The advisor is betting that you’ll focus on the prize itself and neglect the actual odds of him or her being able to achieve it.

Never be lured into playing a game where the odds are stacked against you.

Unless you’re Ruth Hamilton. With her recent luck, she should play lotteries all day long.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.