Market Skew: Another Cause For Investor Underperformance?

Studies have continually shown that the majority of market participants underperform the market. For example, in 2014, 86% of large-cap actively-managed mutual funds failed to beat the S&P 500.

The major factor that causes underperformance among investors is the high fees associated with actively-managed mutual funds. Paying 1% to an actively-managed mutual fund, compared with 0.05-0.10% for an index fund, is a hurdle that is difficult for most fund managers to overcome.

However, there is another factor that explains why so many people underperform the market, and it’s closely linked to why it’s so hard to pick the big winners.

Picking the Diamond in the Rough

Among the many individual stocks in the S&P 500, there have been some big winners as well as some big losers.

For example, Nvidia was a boring, sleepy stock that while a technology company, didn’t get the kind of press that Apple or Amazon would receive. It designs graphic processing units (GPUs) that go into high-end computers and other electronic devices.

But over the past few years, the demand for GPUs has skyrocketed, as people are using GPUs for all sorts of emerging research applications, from playing the board game Go to diagnosing tuberculosis on X-rays and building autonomous vehicles. Everyone wants GPUs, and Nvidia is the leader in GPU production.

As a result, the stock has risen from $27.50 to $197.50 per share in two years, an approximately 168% annualized return.

Unfortunately, success cases like Nvidia are few and far between. The probability of having an Nvidia in a basket of 5 or 10 stocks is fairly low.

The Bell Curve

I’m sure you remember the bell curve in your high school statistics class. For example, the distribution of SAT scores may look something like this:

Medical School Exams Are Skewed To The Left

However, not all exam distributions are normally distributed. For example, a test with a high average may have scores that are all clustered in the 90% range. Since the maximum score is 100%, the score distribution ends up not looking like a bell curve. For example. in medical school, the bell curve of an easy exam might look something like this:

Most students are clustered at the high end of the range, but the poorest-performing students will drag down the average score. This distribution is skewed to the left. The mean test score will be lower than the median (50th percentile) score.

A Question

Let me ask you this: did more or fewer than 50% of the medical students beat the average on the above exam?

More!

In the graph above, 58% of students beat the average score. A person who got the median score (50th percentile) beat the average test score.

Stock Return Distributions Are Skewed To The Right

Instead of being skewed to the left, the histogram of individual stock returns is skewed to the right. Since negative returns are capped at -100%, you can have bigger outliers on the upside than on the downside.

Using data from Investing.com, here are the 1-year returns of the individual stocks that make up the S&P 500.

When the distribution is skewed to the right, the mean (or market return) ends up being greater than the median (50th percentile return). That means that the typical (50th percentile) investor ends up failing to beat the market, even if there were no fees or commissions. Fees and commissions further erode the returns, leading to an even higher percentage of investors underperforming the market.

Bloomberg Article: Why Indexing Works

Bloomberg ran an article a few months back explaining this phenomenon that inspired me to write this blog post. They profile J.B. Heaton, who along with colleagues at Indiana University, use the skewness of individual stock returns to partially explain why individual investors fail to beat the market. In their article, entitled, “Why Indexing Works.” they argue that by owning the entire market, you get rid of the skew in your returns. You achieve the mean return, which will be higher than the median return of an undiversified basket of stocks.

Conclusion

You can add market skew to the list of factors that explain why investors who try to beat the market with individual stocks fail. You can eliminate market skew by owning index funds or a large basket of diversified stocks.

What do you think? Have you heard of market skew? How much do you think market skew versus other factors contributes to the underperformance of individual investors?

[Charts courtesy of StockCharts.com]