- 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.