Does skewness affect everything?
Illustration: John Chase (1932). Source: Plymouth State University
Large cap stocks are skewed to the upside, over the long run. That is, the bulk of their returns are provided by a few successful companies. This makes intuitive sense: these are the largest companies in the world, and their leadership is constantly shifting. But when a small company makes it big, it provides a huge boost to the average return – like EMC or Dell Computers in the late ‘90s, or Amazon or Facebook now.
With all due respect to Charles Ellis, this makes large-cap stock selection a winner’s game, not a loser’s game. Ellis distinguished between winner’s games and loser’s games in a whole host of areas: tennis, golf, gambling, politics, war. He noted that most of these contests were decided by people not making bad decisions, rather than making good ones. In politics, people often vote against the candidate they don’t like, rather than for the one they like. In tennis and golf, average players want to avoid “unforced errors,” rather than by making spectacular shots
But in buying large-cap stocks, you need to find the emergent winning issues. It doesn’t work to just own glamorous, popular names. Often, that horse has already left the barn. In many cases, those big names are struggling with their own bureaucratic bloat, as well as with competitive pressures. That’s why it’s rare for the biggest firms to remain on top. Everyone wants a piece of the king of the mountain.
Public Domain. Peter Bruegel, Children’s Games
But not all markets work this way. The bond market is different. The best you can do when you buy a bond is get your money back. Yes, there are shades to this picture, with calls and puts and floating rates and sinking funds. But bonds are – for the most part – loans to companies and governments where investors hope to get paid back with interest.
The broad bond indices own the universe of bonds, and in other markets broad exposure usually reduces your risk. But in the bond market, broad exposure increases risk, over the long run. The broad indices include all major issues from all the issuers. They have their greatest exposure to companies that issue the most debt. Well, the most indebted companies are often the ones most likely to run into problems. So the bond indices have a negative skewness problem: their returns are depressed every few years by a few prominent failures, or near-failures.
Since bond investors just want their money back, they can outperform by avoiding companies that don’t look like they will pay their money back. Bond investing really is a loser’s game. That’s why bonds are never boring. The way to win is not to lose, and the way to add value is to avoid the bums.
Douglas R. Tengdin, CFA