Individual stock ownership offers both the hope of great returns (finding the next Google, for instance) and the potential for disastrous results (ending up with the next Lehman).
Because investors are not compensated for taking the risk that their result will be the disastrous one—the market doesn’t compensate investors with higher expected returns for taking risks that are easily diversified away—the rational strategy is not to buy individual stocks.
Unfortunately, the evidence is that the average investor, while being risk averse, doesn’t act that way. In a triumph of hope over wisdom and experience, investors fail to diversify.
Given the obvious benefits of diversification, the question is, why don’t investors hold highly diversified portfolios? One reason is that it’s likely most investors don’t understand just how risky individual stocks are. To correct that lack of knowledge, we’ll review the literature. I’m confident most investors would be shocked at the data on individual stock returns.
Most Stocks Underperform The Market
We’ll begin with a study by Longboard Asset Management called “The Capitalism Distribution” covering the period 1983 through 2006 and the top 3,000 stocks. The authors found that while the Russell 3000 Index provided an annualized return of 12.8% and a cumulative return of 1,694%:
- The median annualized return was just 5.1%, 7.7% below the return of the market.
- The average (mean) annualized return was -1.1%.
- 39% of stocks lost money (even before inflation) during the period.
- 19% of stocks lost at least 75% of their value (again, before considering inflation).
- 64% of stocks underperformed the Russell 3000 Index.
- Just 25% of stocks were responsible for all the market’s gains.
Investors picking stocks had almost a 2-in-5 chance of losing money (meaning they underperformed by at least 1,694%) even before considering inflation, which was a cumulative 107%, and almost a 1-in-5 chance of losing at least 75% of their investment, again even before considering inflation. And there was just greater than a 1-in-3 chance of picking a stock that outperformed the index.
You may be wondering how the Russell 3000 Index can have an overall positive rate of return when the average annualized return for all stocks is negative. The answer lies mostly in the index’s construction methodology. The Russell 3000 is market-capitalization-weighted. This means successful companies with rising stock prices receive larger weightings in the index.
Likewise, unsuccessful companies with declining stock prices receive smaller and smaller weightings. In addition, stocks with a negative annualized return had shorter life spans than their successful counterparts—losing stocks have shorter periods of time to negatively impact index returns.