Risks of Investing in Individual Stocks & Countries
When taking risk, it is always prudent to give yourself a safety net
When it comes to investing, we need to distinguish between two very different types of risk: good risk and bad risk. Good risk is the type you are compensated for, in the form of greater expected returns. For example, shares are riskier than bonds, therefore over time, shares must compensate investors by providing greater expected returns.
The risk, of course, is that the expected does not occur. Similarly, the stocks of small-cap and value companies are riskier than their large-cap and growth counterparts. And just as the risk of owning equities cannot be diversified away, the risk of owning small-cap and value stocks cannot be diversified away. Therefore, small and value stocks must also carry risk premiums.
In addition to the risk of owning shares and the risk of small and value stocks, there is a third type of equity risk—the risk of an individual company.
Consider the case of Enron, once named by Fortune as “America’s Most Innovative Company” for six consecutive years. Its stock achieved a high of $90.75 per share in mid-2000 and then plummeted to less than $1 by the end of November 2001; it eventually declared bankruptcy. Since this type of risk can easily be diversified away, the ownership of individual stocks is one that the market does not compensate investors for taking. Thus, it is bad (uncompensated) risk. And because investing in individual stocks involves taking uncompensated risk, it is more akin to speculating than investing.
The benefits of diversification are obvious and well known. Diversification can reduce the risk of underperformance. It can also reduce the volatility and dispersion of returns without reducing expected returns. A diversified portfolio, therefore, is considered to be both more efficient and more prudent than a concentrated portfolio of less than 15 stocks (which is a portfolio many Australians hold). In addition, the taking of uncompensated risk can be very expensive. 2020 provided a reminder of just how expensive a lesson it can be.
While the U.S S&P 500 Index returned 18.4% in 2020, 203 (over 40%) of the stocks in the index lost money (i.e., had a return below 0%), and 10 stocks lost at least 47.9%, with the worst performer losing 58%. And 2020 was not an unusual year. In 2019, while the S&P 500 Index returned 31.5%, 55 (over 10%) of the stocks in the index had a negative return, and 10 stocks lost at least 25.4%, with the worst performer losing 60%.
We can also look at the results over the full decade of the 1990s. During this decade, the S&P 500 Index returned 18.2% per annum. During one of the greatest bull markets of all time, 22% of the 2,397 U.S. stocks in existence throughout the decade had negative returns!
While individual stocks do offer the possibility of market-beating returns, they also offer the potential for disastrous results.
Most active fund managers hold a small portfolio of stocks they have a ‘high conviction’ will outperform. In Australia, Standard & Poors’ Persistence Scorecard to the end of 2020 showed only 1.0% of fund managers consistently maintained a top-quartile ranking over a consecutive 5 year period, and only 2.2% of funds consistently beat their benchmark over the same 5 year period. This data suggests it is nigh on impossible to consistently select stocks that are going to outperform. Is it worth the effort?
As you consider the two potential outcomes individual stocks provide—outperformance and underperformance—keep in mind that investors are on average highly risk averse, and the larger the amount involved, the more risk averse they become. One reason for this is most individuals prioritise trying to avoid retiring (or dying) poor as opposed to retiring (or dying) rich.
Individual stock ownership provides both the hope of great returns (finding the next Tesla) and the potential for disastrous results (ending up with the next Enron). Unfortunately, the evidence is that the average investor, while being risk averse, does not act that way—in a triumph of hope over wisdom and experience, they fail to diversify.
Here is a reminder Stewart Partners is not alone in our approach of not recommending individual stocks: https://www.smh.com.au/money/investing/why-economists-think-it-s-mad-to-buy-individual-shares-20210430
Country Risk
The risks that apply to individual stocks also apply to investing in only one country.
Recently our global study group, the Global Association of Independent Advisors, had Nobel laureate, Robert C. Merton, School of Management Distinguished Professor of Finance, MIT, present to us on asset allocation.
In his presentation, Bob examined the Sharpe Ratio of several countries around the world. The Sharpe Ratio was developed by another Nobel laureate and calculates the average return the investor received adjusted for the amount of volatility or risk they were exposed to. A Sharpe Ratio of 100%+ means the risk adjusted return for the investor was attractive. A result below 100% means the returns earned by the investor – whether positive or negative – were not high enough to justify the risk taken.
The table below summarises the Sharpe Ratios for several countries versus the MSCI World Index (i.e., a portfolio of global stocks) over the period January 1970 to March 2021:
The results tell us:
Whilst Australia produced a healthy 0.50% per annum return over the global index, investors in Australia only received 72% of the reward relative to the risk they took.
In contrast, the U.S not only provided a higher alpha of 1.23%pa, but a Sharpe Ratio of 109%, meaning investors were comfortably rewarded for the risks they took.
Many emerging markets, like Malaysia, Korea and India, delivered relatively high alphas or outperformance relative to the global index, they still had Sharpe Ratios below 100%. That is why we aggregate these nations into an ‘Emerging Market’ bucket for investment, as they have a different risk profile and expected return compared to developed nations.
China, despite experiencing an incredible level of economic growth over the period 1970 to 2021, had a negative alpha and very low Sharpe Ratio.
This analysis tells us that global diversification is a BIG improver of the Sharpe Ratio for a portfolio. We can deliver a globally diversified portfolio for clients at low cost, so it becomes compelling to implement such a strategy.
Summary
As Robert C. Merton said in his presentation, “finance is all about risk”. Without risk, the expected return for an investor is simply the time value of money.
The riskiness of the market changes every day. Why? Because companies generate risk through their daily activities. Most people can live with normal market variations, but want to avoid catastrophic drops.
With this in mind, there are some inherent risks we can reduce in a portfolio, namely holding only a few individual stocks or investing in only one country.
Investors who choose to hold large percentages of their portfolios in individual stocks or only in Australian securities are either directly or indirectly asserting they believe they can beat the market. Otherwise, they would diversify their portfolios and accept market returns, less the cost of investing. They also choose to accept risk that can be diversified away.
For shouldering this diversifiable risk, they should not expect to be compensated with higher returns. And they should also expect greater volatility. Thus, the moral of this tale is purchasing individual stocks is more akin to speculating than investing.
Author: Rick Walker
With thanks to Larry Swedroe, The Risks in Buying Individual Stocks 2 April 2021, from which the first part of this article was taken.