Swedroe: Why Buy Individual Stocks?

January 05, 2015

Individual stock ownership provides both the hope of great returns (for example, if you were to early on discover the next Google) as well as the potential for disastrous results (you could end up with a significant holding in the next Lehman Brothers).

 

But because investors are not rewarded by the markets with higher expected returns for taking uncompensated risk—risk that is easily diversified away—the rational strategy is not to buy individual stocks.

 

Unfortunately, the evidence indicates that the average investor, while nominally risk averse, doesn’t tend to act that way. In fact, individual investors often fail to properly diversify. That is the triumph of hope over wisdom and experience.

 

Individual Stocks Riskier Than Most Believe

Given the obvious benefits of diversification, the question now becomes, Why don’t all individual investors hold highly diversified portfolios? One reason could be that a great many investors don’t understand just how risky individual stocks actually are.

 

I’m confident most investors would be shocked at the conclusions reached in a study by Longboard Asset Management, titled “The Capitalism Distribution.” The study, which covered the period from 1983 through 2007 and the top 3,000 stocks, found the following:

 

  • 39 percent of stocks lost money during the period.
  • 19 percent of stocks lost at least 75 percent of their value.
  • 64 percent of stocks underperformed the Russell 3000 Index.
  • Just 25 percent of stocks were responsible for all of the market’s gains.

 

Investors picking individual stocks had an almost two-in-five chance of losing money, even before considering inflation, and an almost one-in-five chance of losing at least 75 percent of their investment, again before considering inflation. And the odds of picking a stock that outperformed the index were just more than one-in-three.

 

Here’s another great example that demonstrates the riskiness of individual stocks. While the 1990s witnessed one of the greatest bull markets of all time, 22 percent of the 2,397 U.S. stocks in existence throughout the decade had negative returns—not negative real returns, but negative absolute returns.

 

But even this astounding figure is inaccurately low. The reason for this inaccuracy is because the data set includes only stocks that were in existence throughout the decade, thus indicating a high level of survivorship bias.

 

Investors Are Bad At Picking Stocks

 

Compounding the problem is that we know from a series of studies by Brad Barber and Terrance Odean that individual investors are poor stock pickers. For example, Barber and Odean found that the stocks bought by both men and women tend to trail the market after they are purchased. The stocks they sell tend to outperform the market after they are sold. Yet investors persist in this pursuit, a reliably wasted effort. Why? Here’s a brief list of some potential reasons:

 

 

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