Swedroe: Why Buy Individual Stocks?

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:

• The majority of investors have not studied financial economics, reviewed financial economic journals or read books on modern portfolio theory. Thus, they don’t have an understanding of how many stocks are required to build a truly diversified portfolio. Similarly, they don’t have an understanding of the difference between compensated and uncompensated risk. The result is that most investors hold portfolios with assets concentrated in relatively few holdings.
• Professor Richard Thaler of the University of Chicago and Robert Shiller, an economics professor at Yale, note that “individual investors and money managers persist in their belief that they are endowed with more and better information than others, and that they can profit by picking stocks.” This insight helps explain why individual investors don’t diversify. They believe they can pick stocks that will outperform the market. Overconfidence is an all-too-human trait.
• People make investment decisions based on what they believe is important, or what economists call “value-relevant,” information. They virtually never consider the fact that others, with far more resources, almost certainly have the same information. As a result, that information must already be “baked into” market prices. Mark Rubinstein, professor of applied investments at the University of California, Berkeley, put it this way: “One of the lessons of modern financial economics is that an investor must take care to consider the vast amount of information already impounded in a price before making a bet based on information.” Legendary investor Bernard Baruch put it more succinctly, stating: “Something that everyone knows isn’t worth knowing.” Failure to understand this leads to a false sense of overconfidence, which in turn leads to a lack of diversification.
• Investors have the false perception that by limiting the number of stocks they hold, they can manage their risks better.
• Investors who feel they are involved in the process gain a false sense of control over financial outcomes. They fail to understand that it is the portfolio’s asset allocation that determines risk, not who is controlling the switch.
• Investors confuse the familiar with the safe. They believe that because they are familiar with a company, it must be a safer investment than one in a company with which they are unfamiliar. Not surprisingly, this leads such investors to concentrate their holdings in the few companies with which they are familiar. This behavior is reinforced by poor advice, like that from Peter Lynch, to “buy what you know.” Unfortunately, studies have found that the returns of local stocks that investors purchased badly lagged the returns of the local stocks they sold.

Individual Stocks Are Risky

Individual stocks are much riskier than investors believe because stock returns are not normally distributed. In other words, the dispersion of individual stock returns does not resemble a bell curve, where the median return is the same as the mean return. If the dispersion of individual stock returns did in fact resemble a bell curve, then half of stocks would have returns above the mean and half would have returns that fall below the mean.

As you have seen from the literature, this isn’t the case. The explanation is that, while your profits are unlimited, you can only lose 100 percent of your investment. Thus, a few big winners (such as Google) cause the mean (or average) return to be above the median result. Consequently, there are more stocks that have below “average” returns than there are stocks with above “average” returns.

Investors make mistakes when they take idiosyncratic, diversifiable and uncompensated risks. They do so because they are overconfident in their skills; they overestimate the worth of their information; they confuse the familiar with the safe; they have the illusion of being in control; they don’t understand how many individual stocks are needed to effectively reduce diversifiable risks; and they don’t comprehend the difference between compensated and uncompensated risks (basically that some risks are uncompensated because they are diversifiable).

If you have made any of these mistakes, you should do what all intelligent investors do: Once they learn a behavior leads to errors, they correct it.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.