From Gerd Kommer and Marcel Lauterwasser
Although the disadvantages of investing in actively selected individual stocks (stock picking) have been well documented by science for decades and although there have been superior, easily implemented alternatives to individual investments since the invention of index funds in the 1970s, in the practice of our financial advice we often encounter private investors who significantly underestimate the risk of individual stocks. In some cases, not even painful personal experiences with serious losses from individual stocks seem to change one's opinion. (We have the reasons for the unattractiveness of stock picking here briefly summarized; in ours Book they are presented in even more detail and more comprehensively.)
We have often asked ourselves why the underestimation of individual asset risk is so widespread and so fundamental - even among people with commercial experience.
A risk paradox
Behavioral finance - a branch of financial economics research - has provided a number of clever answers over the past 40 years: "cognitive biases" from which almost all of us suffer - regardless of our respective IQ and financial background. [1] But in addition to these psychological pitfalls, there is another little-known reason for the widespread underestimation of individual stock risk: Most private investors do not know how surprisingly short the statistical lifespan, the “life expectancy,” of companies is, and how early or quickly companies die on average.
To illustrate this point, we proceed in three steps. Step 1: We present data and facts about the statistical life expectancy of companies. Step 2: We clarify why so few of us know this remarkable information. Because we don't know them, we as private investors cannot draw the obvious conclusions from an investment perspective, namely systematic diversification, i.e. only investing small parts of our own assets in a single company. Against this background, in step 3 we analyze the curious investment concept “stocks for eternity” that has recently been propagated in the German financial media and by finfluencers.
The statistical life expectancy of companies
The Failure rate (Failure rate) of newly founded companies (startups) during their first five years of life is around 50% and around 80% during the first ten years (Kotashev 2020, Quora 2024). This means that around four out of five companies collapse before they reach their tenth birthday. [2]
If you define failure more broadly as bankruptcy, liquidation or de facto liquidation with “did not meet the expectations of the founder or founders”, then the failure rate probably rises to over 90% within ten years.
From such data it can be deduced that the “life expectancy at birth” of an American startup is only around 15 to 17 years. This is slightly longer than the life expectancy of a dog and shorter than that of a riding horse. A person born in Western countries today statistically lives five times longer than the average company.
The modified metric “Failure Rate in the Next Twelve Months” decreases a little for each additional year that a company survives. This is where companies differ from mammals such as dogs, horses or people. A company that is, for example, 50 years old has a higher probability of surviving the next twelve months than a company that is only 30 years old. Older and therefore often larger companies are more experienced, usually more broadly diversified, have more loyal customer bases and more financial reserves, which increases their resilience in periods of financial drought. However, one should not conclude from this that old companies are unlikely to transition to nirvana. To illustrate, a few randomly selected individual cases from the recent past: The payment provider Wirecard was 21 years old (bankruptcy in 2020), the real estate company Signa (René Benko) was 22 years old (bankruptcy in 2023), the automobile manufacturer General Motors was 101 years old (bankruptcy in 2009). [3] and the Italian bank Monte dei Paschi 545 years (de facto bankruptcy in 2017).
The “Staying Power” of listed companies
As a shareholder – as opposed to an entrepreneur or venture capitalist – you invest in listed companies. In terms of their age, these are typically companies that have already passed their first two decades of life and are very large compared to most unlisted companies. [4]
We were unable to find any precise information about the median age of a listed company in the USA - based on the entire US stock market of currently 5,600 companies - but from the available data we can deduce that the median age is around 25 years. [5] From an investor's perspective, however, we should not look at the absolute age of listed companies, but rather at the average length of time they have existed as a listed company. For the overall US stock market it is 7.5 years (Bessembinder 2018). If you limit this consideration to the 500 large caps in the S&P 500 Index, their average length of stay in the S&P 500 Index is 21 years (Calder et al. 2021).
A similarly large “turnaround” is also taking place within German large caps, as the composition of the DAX index shows over time. The index was set up in 1988 with 30 members. Of these 30 founding companies, at the end of 2023, 36 years later, there were still 12 members left (in the meantime, the DAX has even been expanded from 30 to 40 members).
Not surprisingly, the most common reason for a company's exit from the stock market or from a conventional stock index is the absolute or relative shrinkage of the company's value, triggered by weak earnings or liquidity and the associated unattractive shareholder returns. A formal bankruptcy (insolvency) is rarely the reason for a stock market exit, but it does happen, and of course more often with small caps and micro caps than with large caps.
Stock market exits due to a company merger are not a fundamental exception to the rule that poor business performance and/or below-average stock returns are the main trigger for stock market exits. We can assume that in the typical corporate merger, a more successful company “swallows” a less successful company. [6] Without the merger, the latter would probably have continued to produce poor numbers until it reached another “negative end” a few years later (common) or a sustainable turnaround occurred (rare).
Because this is the case, according to a study (Bessembinder 2018), in the 90 years from 1927 to 2016, almost 60% of all listed companies (both existing and those no longer listed or dead) in the USA generated a cumulative return over their entire listing period below that of short-term, super-safe government bonds, i.e. returns that are worse than those of overnight money - around twenty times as much high risk. With a randomly selected individual stock investment, you would have underperformed the overall market in 96% of all cases. [7] A later study by Bessembinder and colleagues also confirmed this fact for stock markets outside the USA (Bessembinder et al. 2023).
Jeff Bezos predicts Amazon will go bankrupt
Companies generally have a short life expectancy and most listed companies fail in the stock market biotope after just a few years. Because that's the case, one of the most successful entrepreneurs of the last hundred years, Jeff Bezos, founder and former CEO of Amazon, said in a speech to the astonished Amazon workforce in 2018: "One day Amazon will fail. Amazon will go bankrupt." (see here).
The short life expectancy of companies is also one of the main reasons why most large family assets have completely or largely disappeared within one to four generations of the founding generation, even though the public perception is completely different (Arnott et al. 2015 and here). The statement made by politicians and media representatives that “the rich are getting richer” is true particular Clearly not enough. If you look at individual rich people and non-rich people as an abstract, percentage category, in the wealth distribution that exists at a given point in time regardless of the composition of the category, the opposite is true: “The rich are getting poorer and poorer” (Kommer/Lochner YouTube video 2024).
One of the central influencing factors for this is that companies have a short lifespan and many families who have become wealthy through entrepreneurship keep too much of their wealth concentrated in just one or a few individual companies.
Many would abandon this approach, which is extremely dangerous for family wealth in the long term, if they were aware of how short the life expectancy of companies is.
Few people know about the short life expectancy of companies
Why do we have misconceptions about the typical length of a company's lifespan? There are two reasons for this. The first: We don't know the above figures on the statistical life expectancy and average length of stock market membership of companies because the media almost never reports on them. Why don't they ever report it? This information is too unsexy and its potential for circulation and click rates is low. Reason #2 is this Survivorship bias [8]: The companies we encounter in everyday life and in the media - listed and unlisted - are a highly upwardly biased, unrepresentative sample of all companies in terms of their length of existence. Why? We no longer see any companies that have died or otherwise “ceded” in the past, including the last five to 20 years, in our personal everyday lives or in the media.
“Stocks for eternity”
30 years ago, in 1994, the American finance professor Jeremy Siegel published the investment book “Stocks for the Long Run”, which became a classic of investment literature and was most recently published in a sixth, revised edition in 2022. In his book, Siegel shows that the risk of a diversified buy-and-hold portfolio of stocks is lower than many people think, as long as you consider risk Shortfall risk interpreted over periods longer than approximately ten years [9] and that stocks strongly outperform interest-bearing investments in the long term. In 2016, a German translation of the Siegel classic was published under the unfortunate and misleading title “Stocks for eternity”.
This translation probably expresses the opposite of what Siegel actually means. In his “Investment Book on Capital Market History”, Siegel describes the dramatic evolution in the composition of the stock market over longer phases, e.g. B. that the 5,600 US stock exchange stocks that exist today are compared to a good 20,000 that were listed at one time between 1926 and today, but disappeared from the stock market through bankruptcy, corporate merger, de-listing or in some other way.
We know from thousands of studies since the 1970s that stock picking produces statistically poor returns. Using stock picking to initially select a handful of stocks and then not changing anything “for all eternity” is likely to work just as badly as other, more active stock picking methods. Anyone who thinks for a moment about the childish idea of “stocks for eternity” will realize how much its outcome depends on individual luck or bad luck in the initial selection.
But that didn't stop a German investment magazine from creating an index called “Stocks for Eternity” in May 2022 (WKN SL0F99). The German branch of the US bank Morgan Stanley has created over 15 different investment certificates based on this strange index (see, for example, WKN DA0ABN). In the two years since its launch, the index has underperformed the MSCI World Index by over 27 percentage points (as of August 5, 2024). This is not a good start to eternity.
Conclusion
The statistical life expectancy of a company only slightly exceeds that of a dog. The average listed company only survives on the stock market for around seven years, while large caps survive around 20 years.
The main reason why companies disappear from the stock market or from planet Earth in general is subpar profitability.
The short life expectancy of companies and the short average listing time illustrate that companies are fragile organisms.
The short life expectancy of companies is one of several factors why a purely rational private investor household should not invest significant funds in individual stocks with which it pursues one of the following three investment goals:
- Long-term asset accumulation for retirement planning purposes,
- Preservation of assets for the current or future generation,
- Paying for your own current living expenses (consumption of assets).
With stock index funds/ETFs, the individual value risk can be completely diversified away without incurring structural risks. “Indexers” benefit from the fact that the global stock market – unlike fragile individual companies – is a resilient, “ultra-stable” organism that will probably live as long as humanity itself.
Endnotes
[1] See “List of cognitive biases” in the English Wikipedia.
[2] The figures presented below refer to the USA because - as is often the case with economic issues - the most granular and easily accessible data exists for the USA. However, we can assume that these numbers can also be transferred quite well to Germany and other countries.
[3] The fact that GM still exists today does not change the bankruptcy in 2009. The existing shareholders lost almost 100% of their capital back then.
[4] About 0.1% of all American companies are publicly traded.
[5] The median, as the mean, is lower than the arithmetic average, as is the case with many data distributions.
[6] The parallels to the phenomenon of “eat and be eaten” and “survival of the fittest” in nature are not coincidental.
[7] Risk measured as volatility of monthly returns. Other types of individual value risks such as total loss do not exist at all with risk-free investments and with broadly diversified stock portfolios.
[8] See entry “Survivorship Bias” in the German Wikipedia.
[9] Shortfall risk, as defined here, is the probability of falling below a specified threshold return over a specified observation period.
literature
Arnott, Robert/William Bernstein/Lillian Wu (2015): “The Rich get poorer – The Myth of Dynastic Wealth”; In: Cato Journal, 2015, Vol. 35, Issue 3 (see here)
Bessembinder, Hendrik (2018): “Do Stocks Outperform Treasury Bills?”; In: Journal of Financial Economics; 129; 2018
Bessembinder, Hendrik et al. (2023): "Long-Term Shareholder Returns: Evidence from 64,000 Global Stocks; March 7, 2023; SSRN - Internet reference here
Calder, Ned et al. (2021): “2021 Corporate Longevity Forecast”; May 2021; Innosight; Internet reference here
Dial, Minter (2017): "What's The Expected Lifespan Of Your Company? Why Should You Care?": 11 Oct. 2017 – Internet reference here
Garelli, Stephane (2016): “Why you will probably live longer than most big companies”; IMD; Internet reference here
Kotashev, Kyril (2024): “Startup Failure Rate: Ultimate Report + Infographic”; Jan 09, 2024; Internet reference here
Quora (2014): “What percentage of start-ups fail?”; July 20, 2024; Internet reference here
Watson, Richard (2017): “Why companies die”; Imperial College London; Internet reference here