The Perils of Owning Individual Stocks - More Losers than Winners
Individual stock ownership offers both the hope of great returns (finding the next Google or CSL, for instance) and the potential for disastrous results (ending up with the next Lehman Brothers or ABC Learning).
Because 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 frequently fail to diversify.
Given the accepted benefits of diversification, the question is, why don’t investors hold highly diversified portfolios? One reason is that it is likely most investors don’t understand just how risky individual stocks are. To correct that lack of knowledge, this article reviews some of the available research. We think most investors will be shocked at the data on individual stock returns.
MOST STOCKS UNDER PERFORM 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 U.S stocks. The authors found that while the Russell 3000 Index (which tracks the share price of the 3,000 largest listed U.S stocks) provided an annualised return of 12.8% over this 24-year period and a cumulative return of 1,694%:
The median annualised return of the 3,000 stocks was 5.1%, which was 7.7% below the return of the market.
The average (mean) annualised return of the 3,000 stocks 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%) before adjusting for 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 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 annualised return for all stocks is -1.1%. The answer lies mostly in the index’s construction methodology. The Russell 3000 is market-capitalisation-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 annualised return had shorter life spans than their successful counterparts—losing stocks have shorter periods of time to negatively impact index returns.
Here’s another great example of the riskiness of individual stocks. While the 1990s witnessed one of the greatest U.S bull markets of all time, with the Russell 3000 providing an annualised return of 17.7% and a cumulative return of almost 410%, 22% of the 2,397 U.S. stocks in existence throughout the decade had negative returns. Not negative real returns, but negative absolute returns (meaning they underperformed by at least 410%).
Over the decade, inflation was a cumulative 33.5%, meaning they lost at least 33.5% in real terms. Even this shocking figure is inaccurately low because the data includes only stocks that were in existence throughout the decade—there is a large survivorship bias.
GOVERNMENT BONDS OUTPERFORM MOST STOCKS
Hendrik Bessembinder contributed to our understanding of the risky nature of individual stocks with his January 2017 study, “Do Stocks Outperform Treasury Bills?” His study covered the period 1926 through 2015 and included all common stocks listed on the New York Stock Exchange (NYSE), Amex and Nasdaq exchanges. The key findings were:
More than four out of every seven stocks do not outperform Treasury bills over their lifetimes. A Treasury bill is regarded as a risk-free asset, and consequently has a low rate of return.
The 86 top-performing stocks, less than one-third of 1% of the total, collectively accounted for more than half of the wealth creation. And the 1,000 top-performing stocks, less than 4% of the total, accounted for all of the wealth creation. The other 96% of stocks just match the return of riskless one-month Treasury bills.
The implication is striking: While there has been a large equity risk premium available to investors, a large majority of stocks have negative risk premiums. This finding demonstrates just how great the uncompensated risk is that investors who buy individual stocks, or a small number of them, accept—risks that can be diversified away without reducing expected returns.
WHY TRADITIONAL ACTIVE UNDER PERFORMS
Bessembinder concluded that his results help to understand why active strategies, which tend to be poorly diversified, most often lead to underperformance.
The results also serve to highlight the important role of portfolio diversification. Diversification has been said to be the only free lunch in investing. Unfortunately, most investors fail to use the full buffet available to them.
Bessembinder added this observation: “The results here focus attention on the fact that poorly diversified portfolios may underperform because they omit the relatively few stocks that generate large positive returns. The results also help to explain why active portfolio strategies, which tend to be poorly diversified, most often underperform their benchmarks. Underperformance is typically attributed to transaction costs, fees, and/or behavioural biases that amount to a sort of negative skill. The results here show that underperformance can be anticipated more often than not for active managers with poorly diversified portfolios, even in the absence of costs, fees, or perverse skill.”
BEHAVIOURAL ERRORS COMPOUND THE PROBLEM
Compounding the problem of poorly diversified portfolios is that we know from a series of studies by Brad Barber and Terrance Odean that individual investors are poor stock pickers. For example, they found that the stocks both men and women buy trail the market after they buy them, and the stocks they sell outperform after they are sold. Yet they persist in the effort. Why? Following is a brief list of some of the reasons:
The majority of investors have not studied financial economics, read 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. (At Stewart Partners, we think the answer is 8,000+ securities). 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.
Richard Thaler of the University of Chicago, and Robert Shiller, a Nobel Prize-winning 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 that others, with far more resources than they have, almost certainly have the same information. Thus, that information must already be “baked into” prices. Mark Rubinstein, a 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.” The failure to understand this leads to a false sense of confidence, 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 gain a false sense of control over the outcomes by being involved in the process. 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 with which they are unfamiliar. This leads them to concentrate their holdings in a few companies with which they are familiar. Unfortunately, a study found that the returns of local stocks investors purchased badly lagged the returns of local stocks sold.
Many people struggle to separate their emotions from investing. Markets go up and down. Reacting to current market conditions may lead to making poor investment decisions at the worst times. They buy high and sell low.
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%. Thus, a few big winners (such as Google) cause the mean (or average) return to be above the median result. The aforementioned study, “The Capitalism Distribution”, found that 6.1% of the stocks outperformed the market by more than 500%. Consequently, there are more stocks that have below “average” returns than there are stocks with above “average” returns.
Perhaps it is worth heeding the advice from (the late) Merton Miller, Ph.D, Nobel Laureate in Economics:
If there’s 10,000 people looking at the stocks and trying to pick winners, one in 10,000 is going to score, by chance alone, a great coup, and that’s all that’s going on.
Don’t confuse luck with skill. If a stock picking “guru” recommends a sufficient number of individual stocks, some of them will be “winners.” But the odds are against you.
Author: Rick Walker
With thanks to Larry Swedroe and his article “Why buy individual stocks” 15 January 2015