Not investing has its own costs

Nothing is without risk, including when it comes to investing money. But whoever stuffs his or her wealth under a mattress to avoid risk ends up facing a different risk: the creeping erosion of the value of his or her cash. Whoever would like to preserve the purchasing power of his or her money cannot get around investing it (in stocks). But that, too, has its pitfalls. Having access to investment experts and to a sophisticated range of investment products can help you to dodge hidden hazards and boost the real value of your assets.

Nothing is without risk when it comes to money

“Your capital is at risk” – this notice, like other warnings, belongs to the financial industry’s standard repertoire. However, it is such a standard phrase that people are all too happy to click past it or skip over it and it thus fails to fulfill its intended purpose: i.e. to enlighten (potential) investors about the risk of incurring losses on invested capital. The UK’s Financial Conduct Authority (FCA) thus called the small-print, boilerplate risk warning “white noise” in a research report published in January 2022. Forty-five percent of the do-it-yourself investors surveyed in the FCA study were in fact unaware that there’s a potential risk of losing invested money. Through experiments, the FCA demonstrated that “louder” risk warnings – for example in boldface type and with a red background – would be more effective than the standard disclaimers currently in use. However, investors shouldn’t let themselves be deterred by more prominent warning notices or more detailed online risk disclosures in the future because whoever prefers to let his or her wealth sit in a bank account out of fear of facing too much “risk” shouldn’t forget that stashing one’s wealth under the proverbial mattress also presents a risk – the risk of losing purchasing power. Why? Because inflation causes (cash) money to lose value every year. Even at an inflation rate of just 2% per annum – a regime that many central banks deem as monetary stability –, the amount of goods or services that one unit of money can purchase decreases substantially as the years go by. Even the world’s most value-retaining currency – the Swiss franc – has lost a good two-thirds of its purchasing power over the decades since 1970. At the moment, though, most central banks have yet to reach their 2% inflation targets. If one makes an admittedly somewhat exaggeratedly pessimistic assumption that future inflation will stay as high as the average seen over the last 12 months, this means that the US dollar would lose another 85% or so of its value by 2050 while the euro (measured in terms of German inflation) would lose around 90% and the British pound would devalue by 95%.

Socking away money in a piggy bank isn’t risk-free | Not investing costs money

History: Purchasing power of 1 Swiss franc (US dollar, British pound, Japanese yen, euro) since 1970

Sources: Bloomberg, Kaiser Partner Privatbank

The compounding interest effect… | …to the disadvantage of piggy bank savers

Scenario: Purchasing power of 1 Swiss franc (US dollar, British pound, Japanese yen, euro) by 2050 based on average inflation rate over last 12 months (in parentheses)

Sources: Bloomberg, Kaiser Partner Privatbank

Investors therefore should also take a different kind of risk warning into account: i.e. not investing is risky. Whoever would like to protect his or her wealth from losing real value has to invest it. The best (and most easily accessible) protection against a loss of purchasing power is to invest in businesses by buying shares in them. In the near term, the performance of stocks can sometimes be very volatile, but the longer the investment horizon, the more robust their returns and the more likely it is that they will outperform classical alternatives like bonds or gold. Thanks to the compounding interest effect, which Albert Einstein called the eighth wonder of the world, investments in stocks not only can preserve the purchasing power of one’s wealth, but can also increase it considerably when adjusted for inflation. The fact that stocks should yield a higher return than the risk-free interest rate or bonds do is one of the ABCs of stock-market knowledge and is the foundation of the strategic asset allocation for billions upon billions of assets under management around the world. Selecting the right stocks, though, is more important than one might think.

Buy and hold (the boring way) | Stocks return the most in the long run

Cumulative performance taking the USA as an example

Sources: Bloomberg, Kaiser Partner Privatbank

The longer the investment period… | …the steadier the investment performance

Rolling returns on S&P 500

Sources: Bloomberg, Kaiser Partner Privatbank

Wheat and (lots of) chaff

This is because although aggregate price levels on the equity market invariably head upward in the long run, this isn’t true by a long shot for every individual stock. The opposite is true, in fact, because many stocks underperform short-term (risk-free) government bonds or lose value over a long time horizon. Arizona State University Professor Hendrik Bessembinder has taken up this subject in multiple studies. In a research paper published in 2018,¹ he demonstrated that over the period from 1926 through 2016, only 42.6% of all stocks listed on US exchanges performed better (including reinvested dividends) than 1-month T-bills. More than half of all stocks actually even destroyed shareholder value in the long run. However, it’s not exclusively an American problem that so many stocks do not help investors to preserve their purchasing power or are even a total bust – it’s actually a worldwide phenomenon. Bessembinder delivered the latest data on this in an updated working paper published in March 2023.² And even if an investor does succeed in largely skating around value-destroying stocks when picking equities, the return on investment still doesn’t necessarily turn out satisfactory enough because it’s also a statistical truth that only a very small percentage of positively performing stocks account for the bulk of the equity asset class’s overall performance. Depending on the equity market in question, over the period from 1990 to 2020, for instance, the top 1% of the best-performing stocks accounted for 34% (Israel) to 72% (South Korea) of the aggregate equity value appreciation.

Many stocks are detrimental to one’s wealth | One should nonetheless invest anyway

Percentage of stocks with a long-term negative return, 1926–2016

Sources: Bessembinder et al. (2023), Kaiser Partner Privatbank

The winner takes all | Stock returns are not uniformly distributed

Contribution by best performers (top 1% of all stocks) to the total return on local equity markets, 1990–2020

Sources: Bessembinder et al. (2023), Kaiser Partner Privatbank

What conclusions can be drawn from these statistics? Once again it becomes clear that stock-picking is a difficult thing to get right. It requires special expertise, and very few people consistently succeed at it over the long haul (note: somewhat better chances for success exist in smaller markets like the Swiss equity market, which are usually less covered by analysts). But anyone with enough luck or skill can earn considerably above-average profits with a concentrated portfolio of stocks. The stock-picking problem can be circumvented by employing passive investment strategies that replicate a market capitalization-weighted stock index. Going that route automatically makes an investor increasingly heavily invested in winning stocks. But the return on investment with this strategy can never beat the benchmark. Private markets offer a different way to get in on the winners of the future early on. Growth companies these days are staying in private hands for longer and longer and usually don’t go public until after the bulk of their value appreciation has already taken place (and has accrued to venture capitalists). However, the era in which investments in venture or growth capital were the exclusive preserve of institutional investors is over by now.

1) Hendrik Bessembinder (2018): “Do Stocks Outperform Teasury Bills?”

2) Hendrik Bessembinder, Te-Feng Chen, Goeun Choi, K.C. John Wei (2023): “Long-term shareholder returns: Evidence from 64’000 global stocks”