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Previously, we’ve discussed how a small number of exceptional stocks account for a significant portion of the total wealth generated by investing in the equity market. Investors who were fortunate enough to find, purchase, and hold onto these stocks fared remarkably well. But how challenging was the journey?
Michael Mauboussin and Dan Callahan analyzed data from 6,588 U.S. stocks since 1985 in a recent report for Morgan Stanley. We finally took the time to thoroughly review their findings, and they are quite fascinating.
To recap, Professor Bessembinder from Arizona State University examined about 28,600 companies listed in the U.S. from 1926 to 2024. He discovered that most stocks did not outshine U.S. Treasury bills in returns and noted that only 2% of these stocks generated 90% of the total wealth in the market.
Since 1985, the S&P 500 has faced several significant declines, with the dotcom crash erasing over 40% of its value and the global financial crisis reducing it by more than 50%:
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It’s logical that individual stocks can be much more volatile than a well-diversified stock index.
However, we were still surprised to find that, according to Mauboussin and Callahan, the *median* stock has witnessed an 85% drop since 1985. This median stock typically never fully recovers but manages to rebound to about 90% of its highest value.
In contrast, the average stock does recover and triples its value prior to the crash—primarily because this average incorporates standout stocks like Amazon, Apple, and Nvidia, which suffered declines of 95%, 83%, and 90% respectively, before rebounding and exceeding their original peaks.
The authors compiled a table showing the outcomes of all the stocks they analyzed, and naturally, we transformed it into a visual representation.
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This serves as a reminder that many stocks can experience severe downturns. As the authors quote Charlie Munger:
if you’re not willing to accept a market price drop of 50% two or three times a century, you’re not fit to be an ordinary shareholder.
Most stocks are not owned directly by individuals; they are typically held by pension funds, insurance companies, banks, corporations, mutual funds, etc. Perhaps these professionals can navigate through extensive downturns while still achieving better returns?
Focusing on mutual fund data, Mauboussin and Callahan opine otherwise. Among roughly 1,000 U.S. equity mutual fund returns since 2000, they found that the top 20 funds encountered an average decline of 60%. The highest-performing fund suffered a 68% reduction on its way to success.
Even with perfect foresight, any long-term investor will face significant losses now and then.
To support this, they reference a paper from nearly ten years ago by Wesley Gray, CEO of Alpha Architect, an asset management firm. Gray created stock portfolios with perfect foresight every five years starting in 1927. The first portfolio experienced a 76% drop, leading Gray to contend that “even God would get dismissed as an active investor.”
Losing three-quarters of a client’s investment is rarely a favorable outcome. However, if the overall market suffers similarly, such poor performance is often not a reason for termination. FT Alphaville examined the top 10 drawdowns in Gray’s study, discovering that seven not only lost substantial amounts of money but also underperformed weak markets by an average of 650 basis points. Hence, we can empathize with Gray’s standpoint.
So, when your fund manager falls short of expectations and claims they can recover if you keep paying their fees, should you put your trust in them?
Most people do not. This revealing chart from McKinsey’s 2023 North American asset management study highlights just how patient mutual fund investors are with their chosen active mutual fund manager:
Investors are not particularly patient. Fund managers whose three-year performance rankings fall outside the top decile—or those with notably high fees—can expect to see withdrawals.
What conclusion can we draw? If you believe that your manager possesses extraordinary stock-picking skills, it might be wise to refrain from making major decisions or operating heavy machinery and seek professional help. Yet, on the flip side, you should likely avoid dismissing them when they present dismal short-term performance numbers.
Who knows, perhaps even Cathie Wood will make a comeback?
