The risks in buying individual stocks

Posted by Robin Powell on April 2, 2021

The risks in buying individual stocks

 

By LARRY SWEDROE

 

Even the smartest, most determined fund picker can’t escape a host of nasty surprises. Next time you’re tempted to buy anything other than an index fund, remember this — and think again.

— Robert Barker, It’s Tough to Find Fund Whizzes, BusinessWeek.com, December 17, 2001

 

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 that you are compensated for taking. The compensation is in the form of greater expected returns. For example, equities are riskier than fixed-income investments. Therefore, equities 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 equities 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 the taking of 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. 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 S&P 500 Index returned 18.4 percent in 2020, 203 of the stocks in the index lost money, and 10 stocks lost at least 47.9 percent, with the worst performer losing 58 percent on a price-only basis. And 2020 was not an unusual year. In 2019, while the S&P 500 Index returned 31.5 percent, 55 of the stocks in the index lost money, and 10 stocks lost at least 25.4 percent, with the worst performer losing 60 percent on a price-only basis. Similarly, in 2018, while the S&P 500 Index lost 4.4 percent, 10 stocks lost at least 49 percent, with the worst performer losing 67 percent on a price-only basis. 2009 was a particularly interesting year. While the S&P 500 Index returned 26.5 percent, 40 percent of the 7,608 U.S. stocks produced negative returns. Yet, only 0.4 percent of domestic equity mutual funds lost value.1

We can also look at the results over the full decade of the 1990s. Over the decade, the S&P 500 Index returned 18.2 percent per annum. During 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!2  I reached out to Howard Silverblatt, Senior Index Analyst, Product Management, for S&P Dow Jones Indices (S&P DJI), and asked him for similar data on the last decade. While he was unable to provide the data free of survivorship bias, he reported that while the S&P 500 returned 13.9 percent per annum, a total return of 267 percent, over the decade ending in 2020, 51 of the stocks had negative price-only returns.  

While individual stocks do offer the possibility of market-beating returns, they also offer the potential for disastrous results. Consider that in 2008, 25 percent of U.S. listed stocks lost at least 75 percent of their value. However, only four of the over 6,600 unleveraged open-end mutual funds lost more than 75 percent.3 

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 is that, for most individuals, the main goal is not to retire (or die) rich, but to avoid retiring (or dying) poor. 

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). Since investors are not compensated for taking the risk that a result will be disastrous (just ask investors in once great companies, such as Lehman Brothers, Fannie Mae, Eastman Kodak and Polaroid, to name just a few), the rational strategy is not to play. 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, they fail to diversify.  

Given the obvious benefits of diversification, the question is why investors don’t hold highly diversified portfolios. 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 do not 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.
  • Economics professors Richard Thaler of the University of Chicago and Robert Shiller of Yale noted 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.”4 This insight helps explain why individual investors don’t diversify: They believe they can pick stocks that will outperform the market.
  • 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.

 

How much diversification is needed?

Burton Malkiel, John Campbell, Yexiao Xu and Martin Lettau, authors of the study Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk, found that a dramatic increase in the volatility of individual stocks and a declining correlation of stocks within the S&P 500 Index has led to a significant increase in the number of securities needed to achieve the same level of portfolio risk. They found that for the two decades prior to 1985, a portfolio would have had to consist of at least 20 stocks to reduce excess standard deviation (a measure of diversifiable portfolio risk) to 10 percent. From 1986 to 1997, that figure increased to 50 stocks. Whereas the study found there was a large increase in the volatility of individual stocks, the authors found no increase in overall market volatility, or even industry volatility. The implication of increased volatility of individual stocks and unchanged volatility of the S&P 500 taken together is that correlations between stocks have declined. Reduced correlation between stocks implies the benefits of, and the need for, portfolio diversification increasing over time.

Now consider an investor who wants to achieve broad global asset class diversification. He would need to hold several hundred small-cap and large-cap stocks. Then he would probably have to add a similar number of small-cap and large-cap value stocks, real estate stocks, foreign large-cap stocks, emerging market stocks, and so on. There is simply no way to achieve this type of diversification by building your own portfolio of individual stocks. 

 

The moral of the tale 

Investors who hold large percentages of their portfolios in individual stocks are either directly or indirectly asserting that 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 that the purchase of individual stocks is more akin to speculating than it is to investing.

 

  1. Craig Israelson, Size Matters, Financial Planning (April 2010).
  2. In the Vanguard (Winter 2001).
  3. Investment Advisor (April 2010).
  4. New York Times, March 30, 1997.
  5. John Campbell, Martin Lettau, Burton Malkiel and Yexiao Xu, “Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk,” Journal of Finance (February 2001).

 

Important Disclosure: This article is for educational and informational purposes only and should not be construed as specific investment, accounting, legal or tax advice. The analysis contained in the article is based on third-party information and can become outdated or otherwise superseded at any time without notice.  Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed.  By clicking on any of the links above, you acknowledge that they are solely for your convenience and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Wealth Partners, collectively Buckingham Strategic Wealth® and Buckingham Strategic Partners®. LSR 21-18

 

LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.

 

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© The Evidence-Based Investor MMXXI

 

Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.

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