Many of you think you are long-term investors. Few of you, though, behave as though you are.
I say so for a simple reason. It is unwise to hold individual stocks for the long run, because over time most will be destroyed or severely weakened by what Joseph Schumpeter called “the perennial gale of creative destruction”.
A recent paper by Michael Anyadike-Danes and Mark Hart at Aston Business School has shown just how strongly this gale blows. They studied the 240,000 companies that were launched in 1998. They found that 90 per cent of these closed within 15 years. And even those that survived faced a 10 per cent chance per year of subsequently closing.
Stock market-listed companies have better survival chances, not least because they are bigger. Even for the giants, however, survival is not assured especially as a major stock. Of the original constituents of the FTSE 100 when it was formed in 1984, only 23 are still in the index – and two of them (Lloyds and RBS) thanks only to a government bail-out. Sure, some of the drop-outs were taken over, but others fell into decline and collapse such as Hanson, Thorn EMI or MFI.
In fact, for most stocks prospects are poor. Hendrik Bessembinder at Arizona State University shows that most of the 62,000 shares listed on markets around the world between 1990 and 2018 actually underperformed cash over their lifetimes. UK stocks were no exception. The typical one lost 3.3 per cent per year between 1990 and 2018 even with dividends reinvested.
Decline, then, is the typical fate of a UK stock. One reason we don’t appreciate this is perhaps the same reason why people pay high fees for actively managed funds. We under-estimate the power of compounding. If a stock has only a 3 per cent chance of dropping out of the FTSE 100 in a year we might ignore it. But this means it has a less than 50-50 chance of staying in the index over 30 years.
Something else compounds horribly – uncertainty. On a time horizon of two or three years, you might have a decent idea of a company’s strengths, management quality or ability to fend off competition. Over a 20-year horizon, however, you should have no confidence at all in your judgement of these because we cannot foresee the pace and direction of technical change nor predict its winners and losers. As the futurist Roy Amara said, “we tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run”.
It is therefore unwise to be a genuine long-term buy-and-hold investor in individual stocks, as most will underperform over the long term.
This is especially true for smaller stocks, which lack market power. The FTSE Aim index, for example, has underperformed cash since its inception in the mid-1990s.
You might wonder: if most stocks do badly, why do stock markets rise over the long run?
It’s because of massive gains by a tiny minority. Professor Bessembinder estimates that just 1.3 per cent of shares accounted for all the rise in global markets between 1990 and 2018. And just three stocks alone – Apple, Microsoft and Amazon – account for 6 per cent of it.
To beat the market over the long term therefore requires us to identify the tiny minority of future superstars. Most investors cannot do this. Even Amazon’s share price fell by 90 per cent during the tech crash of 2000-02, implying that investors had no clue that it would become a global monopoly within a few years.
What, then, should a long-term investor do? Buying into today’s monopolies isn’t enough. Yes, Alphabet has better ability to fend off competitors than Netscape did, and Facebook has better prospects than MySpace – not least because both buy up potential rivals. But you are paying a premium price for this monopoly power.
Instead, the obvious possibility is simply to hold a global tracker fund. It guarantees you exposure to the Apples and Amazons of the next generation, whatever they are. And, indeed, wherever they are. Thirty years ago, Japanese stocks were regarded as the future while the US was out of favour. This fact alone reminds us that a lot can change over an investment lifetime.
But is a global tracker enough? It invests only in listed companies. And these are a small sample of all companies.
And a biased sample. Companies tend to float on the market after they’ve enjoyed good growth. The University of Florida’s Jay Ritter has shown that newly floated companies on average underperform horribly in their first three years on the market. If you buy only listed companies, then, you miss out on that early growth and buy at the top.
What’s more, listed companies with dispersed shareholders aren’t very good at growing. If managers focus on pleasing shareholders by hitting earnings expectations for the next quarter they might well be distracted from developing the company over the long term.
If you invest only in listed companies, therefore, you are betting that a particular type of corporate structure is the best. This is as daft as betting that growth will be confined to one country or sector. An obvious way to diversify this position is to hold some private equity investment trusts. Yes, these have problems: they are a bet on fund managers’ ability and only give us exposure to a subset of companies when ideally we might want to back the field rather than particular horses. But they do offer some diversification.
A genuine buy-and-hold should be as passive as possible. This is because we know nothing about the long term and so should take as few positions as possible. You cannot be both a long-term investor and a stockpicker.
