By the end of this section, you will be able to:
- Explain overall equity market behavior over various historical periods.
- Explain different equity style and size behavior over various historical periods.
- Extract various equity market performance results from plots and charts.
Using Graphs and Charts to Plot Equity Market Behavior Stock Size Considerations
The Dow Jones Industrial Average (DJIA), also known as the Dow 30) and the S&P 500 Index are the most frequently quoted stock market indices among scholars, businesses, and the public in general. Both indices track the change in value of a group of large capitalization stocks. The changes in the two indices are highly correlated.
It may be fair to question if either index is a good representation of the value of equity and the changes in value in the market because there are over 6,000 publicly traded companies listed on organized exchanges and thousands of additional companies that trade only over the counter. As of year-end 2020, the S&P 500 firms had a combined market capitalization of $33.4 trillion, about 66% of the estimated US equity market capitalization of $50.8 trillion.20 It is widely agreed that the performance of the S&P 500 is a good representation of the broader market and more specifically of large capitalization firms.
Figure 12.13 provides a visualization of how S&P 500 stock returns have stacked up since 1900. This figure makes it clear that equity returns roughly follow a bell curve, or normal distribution. Thus, we are able to measure risk with standard deviation. A lower standard deviation of returns suggests less uncertainty of returns and therefore less risk.
Capital market history demonstrates that the average return to stocks has significantly outperformed other financial security classes, such as government bonds, corporate bonds, or the money market. Table 12.4 provides the return and standard deviation of several US investment classes over the 40-year period 1981–2020. As you can see, stocks outperformed bonds, bills, and inflation. This has led many investment advisers to emphasize asset allocation first and individual security selection second. The intuition is that the decision to invest in stocks rather than bonds has a greater long-run payoff than the change in performance resulting from the selection of any individual or group of stocks.
Figure 12.14 demonstrates the growth of a $100 investment at the start of 1928. Note that the value of the large company portfolio is more than 50 times greater than the equal investment in long-term US government bonds. This supports the importance of thoughtful asset allocation.
Still, the size of a firm has a significant impact on how investors choose equity securities. Capital market history also shows that a portfolio of small company stocks has realized larger average annual returns, as well as greater variability, than a portfolio of large companies as represented by the S&P 500. Small-cap stock total returns ranged from a high of 142.9% in 1933 to a low of -58.0% in 1937.
More recently, the differential return between small and large capital stocks has not been as pronounced. From 1980 through 2020, the Wilshire US Small-Cap Index has averaged an annual compound return of 12.13% compared to the Wilshire US Large Cap Index average of 11.82% over the same period. The 31-basis point premium is much smaller than that realized in the 1926–2019 period, which saw a small-cap average annual compounded return of 11.90% versus 10.14% for the large-cap portfolio.
|Large company stocks
Warren Buffett has not always been one of the richest people in the world, but he has always been one of the hardest workers. An entrepreneur from an early age, Buffett’s yearbook photo caption noted that he “likes math: a future stockbroker.” Before leaving high school, Buffett had already earned thousands of dollars running a paper route and through one of his start-up businesses of installing and maintaining pinball machines in barbershops.
As they say in Nebraska, “you need to make hay while the sun shines,” and Buffett has made his share of hay, so to speak. In his career, Buffett has accumulated enough hay to be one of the wealthiest people in the world, with a net worth of over $80 billion by the end of 2020.
The “Oracle of Omaha,” as Buffett is known, grew his fortune through investing partnerships and most notably as the chairman, president, CEO, and largest stockholder of Berkshire Hathaway (BRK). Berkshire Hathaway was a New England textile manufacturer when Buffett and his investment partners began buying shares in the 1960s. By 1966, after a dispute with the then CEO of Berkshire, Buffett assumed control of the company and fired the CEO. Soon, Buffett’s partnerships merged into Berkshire and moved the business away from textiles; it eventually became the largest financial services company in the world, including total ownership of the Geico Insurance Company.
Buffett’s career is notable for how he developed his fortune, how he explained his philosophy, and for his current and future plans. Buffett followed the method of Benjamin Graham, famous value investor and author of Security Analysis, The Intelligent Investor. However, Buffett expanded beyond Graham’s analysis of financial statements and intrinsic value to examine the character of executive management. He applied the same criteria to hiring employees as well. Buffett once noted, “We look for three things when we hire people. We look for intelligence, we look for initiative or energy, and we look for integrity. And if they don’t have the latter, the first two will kill you, because if you’re going to get someone without integrity, you want them lazy and dumb.” When speaking of integrity, Buffett went on to say, “Only when the tide goes out do you discover who’s been swimming naked.”
Buffett’s folksy way of making his point will undoubtedly be another of his legacies. When asked repeatedly about how he managed to be such a successful investor, Buffett replied, “Never invest in a business you can’t understand.” Never was this truer than in the late 1990s and 2000, when the dot-com craze fueled the stock market with technology firms enjoying tremendous price increases without the corresponding earnings. Buffett’s value investing lagged until the bubble burst, and suddenly he was back on top. When asked about his change in fortune he replied, “In the business world, the rearview mirror is always clearer than the windshield.”
Buffett believes in long-term rather than short-term investing. He once remarked that “Someone’s sitting in the shade today because someone planted a tree a long time ago” and “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”
The third aspect of Buffett’s legacy will be how his money works now and after he is gone. With Bill and Melinda Gates, Buffett started the Giving Pledge, and to date they have gathered the pledge of over 200 billionaires to give away half or more of their fortune during and after their lifetimes. Buffett states, “If you’re in the luckiest 1% of humanity, you owe it to the rest of humanity to think about the other 99%.” Buffett has begun the process to give away most of his fortune, but he has left this pearl of wisdom for his own children: “A very rich person should leave his kids enough to do anything, but not enough to do nothing.”
(Sources: Joshua Kennon. “How Warren Buffett Became One of the Wealthiest People in America.” The Balance. May 4, 2021. https://www.thebalance.com/warren-Buffett-timeline-356439; Ty Haqqi. “Five Largest Financial Services Companies in the World.” Insider Monkey. November 26, 2020. https://www.insidermonkey.com/blog/5-largest-financial-services-companies-in-the-world-891348/2/; Mohit Oberoi. “Warren Buffett: Growth Stocks Look Like Dot-Com Bubble.” Market Realist. September 4, 2020. https://marketrealist.com/2020/07/warren-buffett-growth-stocks-like-dot-com-bubble/)
- 20Spencer Israel. “The Number of Companies Publicly Traded in the US Is Shrinking—Or Is It?” MarketWatch. October 30, 2020. https://www.marketwatch.com/story/the-number-of-companies-publicly-traded-in-the-us-is-shrinkingor-is-it-2020-10-30; Siblis Research. “Total Market Value of US Stock Market.” Siblis Research. https://siblisresearch.com/data/us-stock-market-value/
- 21Karl Steiner. “Historical Returns of Global Stocks.” Mindfully Investing. July 6, 2020. https://www.mindfullyinvesting.com/historical-returns-of-global-stocks/; Elroy Dimson, Paul Marsh, and Mike Staunton. Summary Edition Credit Suisse Global Investment Returns Yearbook 2020. Credit Suisse, February 2020. https://www.credit-suisse.com/media/assets/corporate/docs/about-us/research/publications/credit-suisse-global-investment-returns-yearbook-2020-summary-edition.pdf