Sticking with the status quo comes with a price

Published in The Sunday Times on 8th December 2024.

If I owed you €100 and offered you a coin flip agreeing to pay you €200 for heads and to call it quits if it comes up tails, would you take it? Alternatively, if you owed me €100 and I offered you the same bet – heads we are quits and tails you owe me €200. What would you do? 

In repeated tests, people overwhelmingly choose €100 in the first example and take the coin flip in the second.

Loss aversion

This is just another form of the well documented cognitive bias in behavioural economics referred to as risk aversion, or loss aversion, which notes that humans are motivated more forcefully by a fear of losing than by a desire to win.

This particular example highlights an asymmetry in when we want to walk away and when we want to gamble. When faced with a certain gain (I owe you the €100) we don’t want to recruit luck into the equation, so we reject the gamble. When we are facing a loss (you owe me) we want to recruit luck with the hope of avoiding the certain loss – uncertainty doesn’t bother us. 

This asymmetry manifests itself in another important way. We are much more bothered by the downside potential of changing course than we are by the downside potential of staying on the path that we are already on. 

The status quo

We don’t think of sticking with the status quo as an active decision, in the same way we view switching as one. We are more concerned with errors of commission, rather than omission. When you choose to stay, you are also choosing not to go! 

I’m thinking about this in an investment context. If the path you are on is the right one, then choosing to stick, i.e. inaction is to be welcomed. But how many of us are on the right path? 

I’ve lost count of the number of client meetings I have attended in the past year in which clients are “not ready to make a decision yet” in relation to their investment that is sitting in a money market fund. What it really means is “I’m not ready to veer from the status quo”. To be fair, with the ECB deposit rates sitting at just over 3%, they are being paid for their indecision. But in 2024, it’s been a costly one.    

Very strong equity returns in 2024 

As 2024 draws to a close, the risk takers amongst us can bask in the glory of another year of strong double-digit returns. For the eleven months to the end of November the S&P 500 has notched up a dollar gain of 28%, whilst global equities (MSCI World) have delivered 22%.

There’s been a lot of talk this year about the concentration of returns amongst the so-called Magnificent 7. I won’t go over this ground again, but it is worth looking at the returns of individual stocks in the index. 

The best performing stock in the S&P 500 so far in 2024 is a company called Vistra which has returned an extraordinary 321% for the first 11 months. But is it really that extraordinary?

An academic who’s done a lot of research on the history of stock returns is Hendrik Bessembinder. In a fascinating report spanning almost 100 years he looked at the stocks that have generated the highest long-term returns. 

Skewed distribution of individual stock returns

We have seen from his previous work that most individual stocks underperform, but a small number of stocks with colossal returns drive the overall market.

The average stock return is strongly positive (skewed by significant returns from a small number of stocks) while the median outcome is negative. This outcome makes sense because there is no limit to the potential gains for stocks, but as the author notes, “as long as legal systems incorporate limited liability no (individual stock) return can be less than -100%.”

The study highlights that the highest cumulative returns were achieved by stocks with relatively modest annualised returns, emphasizing the significance of long-term investment. The importance of time in the market is a cliché for a reason.  

Altria has been the best performer

For example, Altria Group (formerly Philip Morris) delivered the highest cumulative return since 1928 of 265 million percent -  $2.65 million per single dollar initially invested. This seems hardly credible. But it equates to an annualised return of (only) 16.3%, demonstrating the power of compounding over long periods.

I suppose this is the point. Thinking long-term and staying the course is laudable advice but it presupposes that you are on the right path. For many long-term investors sitting in cash or equivalents, choosing not to invest in stocks, is choosing to stay in cash. But I don’t think many recognise this as an active decision and one that comes with a big price.

Reframe investment outcomes net of inflation

If we were to reframe investment outcomes in inflation adjusted terms we would see the likelihood of loss with so-called safe assets is high. This might motivate more active decision making and avoid the inevitable loss that comes with the status quo. Think about that when drafting your new year resolutions.  

Source: Data is sourced from Bloomberg as at market close 29th December, returns are based on total indices in local currency terms, unless otherwise stated.

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on X at @gconno1.