In February of 1992, an Australian syndicate of 2,500 ‘investors’ attempted to win the Virginia Lottery by buying every number combination. The jackpot had grown to $27 million and while that seems like peanuts compared to an ordinary Powerball or Mega Millions jackpot, back then it was the largest potential payout the state had ever seen.
To the Aussies, it seemed like a good risk because the odds of winning were only 1 in 7,000,000. As long as there were less than 4 winning tickets, they’d make a profit and if they wound up with the only winning ticket, they would almost quadruple their money.
There was one major obstacle, buying the tickets! The drawing was held once a week, on Saturday night and just like today, tickets could only be generated through lottery retailers’ machines. This meant having to scan entry forms individually at store locations and printing tickets.
By the time the decision was made to proceed, there were only 3 days left before the next drawing. And though they had made prior arrangements with the owners of a several stores, it would still be a race against time to get all 7 million entries processed.
At 11:15 p.m. that Saturday night, ticket sales came to a close. Despite almost 3 days of around-the-clock ticket buying at several locations, only 5 million tickets had been obtained. The odds were good they had a winning ticket but definitely not guaranteed as there were still 2 million number combinations they didn’t have. At 11:20 p.m. the ping pong balls went into the machine…
Playing the Market
Investment professionals cringe a little bit every time they hear the stock market compared to some form of gambling. However, recent research of historical stock performance by Hendrik Bessembinder has found that the stock market may be more like a lottery than previously thought.
Anyone who has leafed through their company’s retirement benefits handbook or gone to a “free” dinner seminar hosted by someone like me has heard over and over how the stock market has averaged 10% per year and that stocks outperform bonds over the long term. However, like most rules of thumb, there are caveats of which we need to be aware.
Classic investment management theory is predicated on returns for individual stocks matching the standard bell curve. That is, most stock returns fall somewhere between a little below average to a little above average. And of course there will be a few that do very poorly and a few that do very well.
While true for shorter time frames like a year or two, when Bessembinder looked at individual stock performance over longer periods, 10 years or more, he found a different result. Not only did the vast majority of stocks under perform the average market return, but half of all stocks did worse than Treasury Bills. (Source: Do Stocks Outperform Treasury Bills?)
Since historically T-Bill interest rates are similar to a savings account, another way to think about this is that over any given 10 year period since 1926, your money would have grown faster sitting in the bank than if it had been invested in any or all of the stocks in the bottom half of the market.
Even more surprising; over the 90 years between 1926 – 2015, the entire net gain of the stock market, all $32 trillion of it, can be attributed to just the top 4% of all stocks, or about 1,000 companies. And drilling down further, the top 0.33% (86 stocks) account for over half of the wealth created!
While it has taken almost a century for a number of these 86 stocks (i.e. Coca-Cola, IBM, GE) to generate their massive wealth, some companies such as Google, Apple Computer and Amazon have been around for less than 40 years. Depending on your age, had you, your parents or grandparents invested a meaningful amount of money in the early days of any of these companies, you’d be on a beach somewhere instead of reading this.
The Market is a Lottery Where You Can Buy All the Tickets
A key takeaway of this research is that the stock market is more like a lottery than most people, especially those on Wall Street, would care to admit. When looked at individually, each stock can be considered a slow motion lottery ticket. In time a few will be winners and join the top performing companies of all time, but it’s impossible to know which ones.
So, to invest in the market you need to treat it the same way the Aussies did with the VA lottery. That is, your portfolio must own a lot of different stocks. Fortunately with the rise of index funds this is much easier, and less expensive, to do than it used to be. And while the majority of stocks inside the index fund won’t contribute to your net worth, a few winners will more than make up for the rest.
Of course you can also treat the market as a lottery and take a flyer on a few individual stocks. And though the odds of hitting on the next Amazon are much better than buying a winning Powerball ticket, you’ll need a lot more patience as it may be decades before you (or your kids) know if you’ve hit the jackpot. And, as with any form of gambling, only bet what you can afford to lose.
Speaking of the Lottery, What Happened?
Only 1 ticket matched the winning numbers that Saturday night in 1992. A few weeks later the Aussie investors came forward to claim their prize.