You may have heard of the 4% rule as it pertains to retirement. It goes like this: If you begin retirement withdrawing 4% of your savings and adjust each following year’s withdrawals for inflation, your money should last 30 years. It may be the most widely accepted and most often cited rule of personal finance.
Fewer of us, though, are familiar with the other 4% rule. I admit, it’s not something I was aware of until recently, but the implications of it have further solidified my beliefs about the most appropriate way to invest.
In January of 2017, Hendrik Bessembinder, who is in the finance department of Arizona State’s business school, released an initial draft of a whitepaper he titled, “Do Stocks Outperform Treasury Bills?” If you are unfamiliar with a Treasury Bill, or T-Bill as they are often called, they are short-term debt obligations issued by the U.S Treasury Department that generally mature in less than one year.
From 1926 to 2015 the average monthly return on a T-Bill was 0.38%, or roughly 4.56% annually. Because of the short time frame and their backing by the full faith and credit of the United States of America, they are widely considered the most risk-free asset available. Knowing that, the title of Bessembinder’s whitepaper becomes a bit more provocative. Surely stocks do better than boring ole’ Treasury Bills, right? Turns out, most stocks fail to outperform T-Bills.
To reach this conclusion, Bessembinder looked at every single stock listed on three major exchanges—NYSE, Amex, NASDAQ—from 1926 through 2015. That’s over 26,000 stocks. He found that only 42.1% of them had returns that exceeded a T-Bill and that more than half had negative returns. The best 86 stocks, or roughly .33% of all stocks ever traded on one of the three major exchanges, accounted for half of all the gains in the stock market.
What’s more, all the gains generated by the stock market can be attributed to the best 1,000 stocks. That is, of the 26,000 stocks Bessembinder researched, just 4% account for every penny of wealth the stock market has ever created. The bottom 96%? Nothing. This is the other 4% rule.
As Bessembinder writes, “This study highlights that non-diversified stock investments are subject to the very real risk that they will fail to include the relatively few stocks that, ex post [based on actual results], generate very large cumulative returns.” Most education in the field of investing emphasizes diversification as a means of reducing risk. Bessembinder re-frames diversification as a means of capturing the full returns of the market. Fail to diversify and you could miss out on the small percentage of stocks that generate long-term wealth.
The implications of Bessembinder’s findings are many. It should impact how you think about owning large amounts of employer stock or investing in that stock your friend told you about. It should make you think twice about how investing is depicted in the financial media. Most importantly, it should shift your focus from which stocks to pick to how you can capture the full returns of the market in as efficient a manner as possible.
While Bessembinder’s whitepaper takes a deep dive into why selecting individual stocks doesn’t work, there is ample research available about what does work. All suggests that low fees, tax-efficiency, good behavior, and time in the market (rather than timing the market) provide superior results to concentrated, actively managed portfolios over time.
It’s why we focus on broad market exposure at minimal cost, both in fees and taxes, and ensure you have no more risk in your portfolio than is necessary to accomplish your goals.
The retirement 4% rule may be more popular, but this 4% rule is just as important. If you’d like to learn more about our investment philosophy, or want a second opinion on your current portfolio, please get in touch with us.