When it comes to investing, it’s important to distinguish between two very different types of risk: good risk and bad risk. Good risk is the sort that you are compensated for taking. This compensation comes in the form of greater expected returns. For example, equities are riskier than safe bonds, such as Treasuries. Therefore, equities must compensate investors by providing greater expected returns.
The risk, of course, is that the expected doesn’t occur. In traditional financial theory, 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, neither can the risk of owning small-cap and value stocks. As a result, 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’s a third type of equity risk — the idiosyncratic risk of an individual company. Because this type of risk can easily be diversified away, owning individual stocks is a risk the market doesn’t compensate investors for assuming. Thus, it is bad (uncompensated) risk. And because the decision to invest in individual stocks involves taking uncompensated risk, it’s more akin to speculating than investing.
The benefits of diversification are obvious and well-known. Diversification, for example, reduces the risk of underperformance. It can also decrease the volatility and the 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. Let’s examine some evidence that will support this view.
2004 was a “typical” year for stocks, at least insofar as the S&P 500 Index rose 10.9 percent, pretty close to its long-term average annual return. Yet, fully one-third of stocks that were in existence the entire year provided negative returns. And the average loss of those stocks was 25 percent. In other words, more than one-third of all stocks available for investment underperformed the market by an average of at least 36 percentage points.
But even that figure understates the real risk of individual stock ownership because a significant number of stocks disappear each year through bankruptcy or delisting. In short, taking uncompensated risk can be very expensive.
We find similar results when we extend our original timeframe to the 10-year period from 1995 through 2004. While the S&P 500 Index returned 12.1 percent per year, 16 percent of the 2,781 stocks that survived the period lost money. The average loss was almost 10 percent per year, which means they underperformed the market by more than 20 percent annually. Keep in mind that, as we extend the timeframe, survivorship bias within the data increases.
Similarly, in the decade of the 1990s, the S&P 500 Index returned 18.2 percent per year, but 22 percent of the 2,397 U.S. stocks in existence throughout the period posted negative returns.
2006 provided us with more evidence on the speculative nature of individual stock ownership. The S&P 500 Index returned 15.8 percent. However, 2,414 stocks (almost 40 percent of the 6,133 stocks listed in the Morningstar Principia database) produced negative returns. Their average equal-weighted return was a negative 30.5 percent. In all, 562 stocks (or 9 percent) lost more than 50 percent and 80 stocks (or greater that 1 percent) lost 90 percent or more.
And in 2009, while the S&P 500 Index rose 26.5 percent, 40 percent of the 7,608 U.S. stocks in existence produced negative returns.
While individual stocks do offer the possibility of market-beating returns, they also offer the potential for disastrous results. For example, in 2008, 25 percent of stocks listed in the U.S. lost at least 75 percent of their value. However, only four of the more than 6,600 unleveraged, open-end mutual funds lost greater than 75 percent.
As you consider the two potential outcomes that owning individual stocks can provide — outperformance and underperformance — keep in mind that investors are on average risk averse, and they become more risk averse the larger the amount of money involved.
Investors are Risk Averse
An illustration of the risk-averse nature of individuals is the game “Outfox the Box.” In this game, you are an investor with a difficult choice to make. You are shown nine boxes, each representing a rate of return you are guaranteed to earn for the rest of your life. The returns you would have to choose from are as follows:
Now comes the decision. You can either choose to accept the 10 percent rate of return in the center box, or you will be asked to leave the room. At this point, the boxes will be shuffled around and you will then choose a box at random, not knowing what return it might hold.
You quickly calculate that the average return of the other eight boxes is 10 percent. If thousands of people played this game and each of them chose a box, the expected average return would be the same as if they all chose not to play.
Of course, some people would earn a return of negative 15 percent per year (ending up very poor), while others would earn 35 percent (ending up very rich). This is much like the world of investing. If you choose an individual stock, you might get lucky and earn as much as 35 percent per year. On the other hand, you might be unlucky and lose 15 percent per year. A rational, risk-averse investor should logically decide to “outfox the box” and accept the average (market) return of 10 percent.
In my years as a wealth advisor, whenever I present this game to an investor, I have never once had an investor choose to play it. While they might be willing to spend $1 on a lottery ticket, they quickly become more prudent when it comes to investing their life’s savings. This occurs because the main goal for the majority of individuals isn’t 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 Google) and the potential for disastrous results (ending up with the next Lehman).
Because investors are not compensated for taking the risk that the result could be a disastrous one, the rational strategy is to choose not to play. Unfortunately, the evidence demonstrates that the average investor, while they may be risk averse, doesn’t act that way. Instead, they fail to diversify. That’s the triumph of hope over wisdom and experience.
Given the obvious benefits of diversification, the question becomes: Why don’t most investors hold highly diversified portfolios? The following is a brief list of some more common reasons:
• The majority of investors have not studied financial economics, read financial economic journals, or researched 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.
• Richard Thaler of the University of Chicago and Robert Shiller, an economics professor at Yale, observe 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 the individual investor doesn’t diversify. They believe they can select 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 an outcome 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 tend to confuse the familiar with the safe. They believe that because they are familiar with a company, it must be a safer investment than a firm with which they are unfamiliar. This leads such investors to concentrate their holdings in a few companies with which they are familiar
Investors who hold large percentages of their portfolios in individual stocks are asserting, either directly or indirectly, that they believe they are able to 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 shouldn’t expect to be compensated with higher returns. But they should expect greater volatility. This makes the purchase of individual stocks more akin to speculating than it is to investing.
Lots of people enjoy going to the racetrack or visiting the gaming tables at a casino. But they don’t take their retirement accounts with them. Rather, they set aside entertainment accounts. Similarly, if you enjoy trying to pick stocks that will beat the market, set aside a very small percentage of your financial assets in a separate “entertainment account.”
You may get lucky and beat the market and you won’t go broke.