In this month’s edition of “Money Matters,” Scott talks about why being “average” in the financial markets can be impressive, and even better in the long-term, than trying to consistently time the market or pick “winners.”

Money Matters: When Average is Better Than Average Transcript

0:00:00.2 CJ: WTIP is pleased to bring you another edition of Money Matters, a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a certified financial planner and adjunct professor. He works with many individuals and has taught retirement planning and wealth management strategies to hundreds of financial professionals, and Scott is joining us now by phone. Good morning, Scott.

0:00:24.5 Scott Oeth: Good morning, CJ.

0:00:26.1 CJ: It's nice to chat with you again. So, you wanted to talk about the power of being average in the stock market. Now, that doesn't sound like one of your more exciting topics. Why did you want to settle for talking about average this morning?

0:00:42.9 Scott Oeth: I know. I know. Not everyone likes the idea of being average, I think, especially in investing. you think capitalism and winners and success and key peak performance. And all those are exciting ideas. Maybe being average isn't so much. But I'll tell you, CJ when you look at the long-term returns of the stock market over the last 100 years, the average is pretty darn impressive. About a 10% average annualized return over the last 100 years. Now, of course, there's bear markets, there's market drops, there's recessions, there's periods of a year or several years, long periods of times where that doesn't play out. But if you stick with the plan, if someone would have been an investor over the last 100 years, they would have been really happy. Because at that rate, at a 10% average annualized return, what that means is their compounding wealth at a pretty impressive rate. Their investment capital is going to be doubling about every seven years. So that average is pretty good. And I think back here we are on the radio, when we listen to Prairie Home Companion, we heard that Lake Wobegon, all the children are above average, right? Remember that. But in the stock market, there's this interesting phenomenon that's absolutely not the case.

0:02:01.0 Scott Oeth: And it's, this is an important concept for most investors to understand. Most of the stocks are well below the average on their long-term returns. It's a bit of a head scratch. You're like, what are you talking about, Scott? How can they be below average? But the idea is the actual performance of all the listed stocks, many of them is not very good, but there's a few super winners, home run hitters that pull up the average return. So, one of the things I want to talk about is there's a guy named Hendrik Bessembinder. He's a professor at Arizona State University. He's a finance professor. He's done a bunch of research into this. And some of his titles, Wealth Creation in the US Public Stock Markets. And he had a great one just Do Stocks Outperform Treasury Bills? Amongst his other research—it's really powerful stuff—and it points to the extreme concentration of returns in a few winners. Bessembinder found that just 4% of the listed US stocks accounted for basically the entire gain of the stock market between 1926 and 2016. And he found that over half the stocks, we're talking about averages here, the majority, 57% of stocks actually led to a reduction in shareholder wealth.

0:03:21.2 Scott Oeth: So as always, our disclaimer here we're just talking about general concepts here and having an informative discussion. This isn't supposed to be specific advice for anyone in particular, you need to do your own research. But there's some real key points for investors here to keep in mind. I think they should consider in terms of how they're structuring their own investments and portfolio.

0:03:40.7 CJ: Well, okay, so how does this research from Bessembinder on that whole historical stock market performance, how does that sort of... How should we be thinking about sort of the traditional notions around investing, given that research?

0:04:00.9 Scott Oeth: Yeah, well, I think it's important. There's just this small number of winners of the overall stock market and many losers or duds that kind of go nowhere or fizzle out. So, we really want to hold those winners. But here's the thing that might lead someone to say, well, okay, I want to be a great stock picker or hire a real expert stock pickers where they're going to pick those winners and avoid all those losers. Why would we want to own those? So, that's a nice idea, but it's very, very difficult to do that consistently. This is probably a great conversation for another day, but the idea of that type of active stock picking where you're picking winners and you're going to avoid all the losers sounds great. Why wouldn't you sign up for that? Well, the reason you wouldn't is because when you look at the numbers there, historically, it's very, very tough to do that on a consistent basis. You've got thousands, hundreds of thousands of very sharp people pouring over every single bit of information out there and trading minute by minute, second by second in the market, and it's just very tough to do that consistently.

0:05:03.8 Scott Oeth: So, I encourage people to think about what you probably want to do, at least with a significant portion of your investment assets in your 401k or your 403b or IRAs, is cast a very wide net. Yes, you'll own many of the losers, which is not a fun thought, but importantly, casting that super wide net being very diversified, you're going to catch those super performers that pull up your long-term averages. So, you get to participate in that rising tide of the market. It's important, and it really comes into play. Sometimes, I meet people fairly frequently and they've built wealth because they've got a concentrated position. One stock or a couple of stocks that worked out very well that maybe they inherited them, or they were smart enough or lucky enough to buy a long time ago or really commonly, CJ, is a company stock. They work for a company, they've done well. There's sort of this, again, challenging notion. You can look at it and say, well, it's very visible. This person built up a really nice nest egg or got to be wealthy by owning primarily one company stock or a large portion of one. It did very, very well for them.

0:06:13.2 Scott Oeth: But you can't really turn that around and say that's a high-probability strategy that's going to work for a lot of people. In fact, one of Bessembinder's pieces is he looked at single stock strategies. He found that they underperformed the valuated market index in 96% of simulations. Yeah, so it's very, very difficult. So, you see these examples, like I say, where someone worked for ABC or XYZ, a prominent company, and it's a big winner. And wow, they got company stock, maybe grant in their 401k, or maybe they're really at a level where they got stock options that worked out very well for them. That's great, but it's difficult to replicate. So, if you're in that position, I think you really want to think about the difference between what happened that got you wealthy or built up a nice dollar amount and what it takes to maintain and preserve that over time. They're really two different things, and so, one of the techniques that I use commonly, CJ, and again, folks, they do their own research, but I think that thinking about the core of your portfolio, what's needed for really the don't screw it up, high probability, consistent approach that is likely to deliver good results for you.

0:07:33.3 Scott Oeth: And you need enough in there to accomplish your goals and to be on track, so you're not disappointed by how things come out in the long term. Then, if you are very interested in trying to pick some winners or have one of these winners that has come up in the past, maybe that's a more modest position, somewhat insulated from the core of your capital that's needed to protect your financial future. And so, you can feel like, okay, I still have some chips on the table here. If they work out well, it's going to be a big win for me, but if they don't, which Bessembinder shows us is likely, it's not going to upset your future either.

0:08:10.7 CJ: Okay. All right. So, take away from all of this, casting the wide net. What else?

0:08:19.9 Scott Oeth: Yeah, casting a wide net in terms of the numbers. You probably really want to own, at least with a large portion of your portfolio, very broad-based holdings. A common way to do that, I think a pretty good way for a lot of people to do that, is what's called index funds. Now, there are lots of different types of index funds, but these are ones where they're not necessarily trying to pick winners and avoid losers. They are just buying big building blocks of the market. So, they decide which types and how much to weight those, but that might be a good thought. They typically are very low cost. They're very tax efficient, and you're going to capture at least that average, which, as I said up front, doesn't always sound that exciting, but the average is awfully good and outperforms a whole lot of the more specific stock picking type strategy. So, I think that's one big takeaway. Something we've talked about a lot, CJ, is not just the holdings that you're picking, but how you own them. And I really think most people, you just want to own them and own them through thick and thin, up and down.

0:09:23.3 Scott Oeth: Think about your exposure, how much you can have at risk, how much you can have in volatile markets, and keep your safety money safe in the bank or other places like that. But it's also time in the market. And the other piece to this is returns can come in very concentrated runs. And the idea of exiting the market because things look scary or entering when things look good, it's very likely that you end up missing these concentrated periods of runs as well as the concentrated holding. So, I think those are some of the real big takeaways, and something else I just wanted to share related to this, CJ, is in the past—back in September of 2020—we did an episode Money Matters talking about investment diversification, age-old wisdom, investment diversification. So, I had a lot of points in there that are really related to this. I think that would be worth your listeners reviewing. I'll post that, and it's on your site, and we've got 4th of July coming up. The last two years, we've done a financial independence episode. So, one in July of 2023 talking about financial independence and then one last year that I've posted, and you have as well, on financial independence and how you can model that and use a tool called Monte Carlo Simulation to help understand. Are you there or what's it going to take to get there?

0:10:45.9 CJ Heithoff: All right. Well, Scott, thank you for this. We appreciate this. There's a lot of information. Usually at the end of this, my head is spinning, but I'll take it all in and I'll refer back to those previous conversations. We really appreciate you taking time to chat with us.

0:11:01.6 Scott Oeth: Great. I really enjoyed it, CJ. Thank you.