Shownotes
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 15: Individual Stocks Are Riskier Than Investors Believe.
LEARNING: Don’t invest in individual stocks. Instead, diversify your portfolio to reduce your risk.
“Diversification has been said to be the only free lunch in investing. Unfortunately, most investors fail to use the full buffet available.”
Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 15: Individual Stocks Are Riskier Than Investors Believe.
Chapter 15: Individual Stocks Are Riskier Than Investors Believe
In this chapter, Larry reveals the stark reality of investing in individual stocks, highlighting the significant risks involved. His aim is to help investors understand the potential pitfalls of this high-stakes game and why they should avoid it.
Given the apparent benefits of diversification, it’s baffling why investors don’t hold highly diversified portfolios. According to Larry, one reason is that most investors likely don’t understand how risky individual stocks are compared to owning a broad selection of hundreds or thousands of stocks.
Evidence that individual stocks are very risky
Larry notes that the stock market has returned roughly 10% per year over the last 100 years, and the standard deviation on an annual basis of a portfolio of a broad market of stocks has been about 20%. He observes that most people don’t understand that the average individual stock has a standard deviation of more than twice that.
In another study from 1983 to 2006 that covered the top 3,000 stocks, the stock market returned almost 13% per annum, but the median return was just 5.1%, nearly 8% below the market’s return. The mean annualized return was -1.1%. This means that if you randomly pick one stock, the odds would say you’re more likely to get -1.1%. However, if you own hundreds or thousands of stocks, the odds are in your favor, and you’ll get very close to that mean return.
Larry shares another stark example of the riskiness of individual stocks. Despite the 1990s being one of the greatest bull markets of all time, with the Russell 3000 providing an annualized 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 absolute returns. This means 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.
In another study by Hendrik Bessembinder of all common stocks listed on the NYSE, Amex, and NASDAQ exchanges from 1926 through 2015 and included. He found:
- Only 47.7% of returns were more significant than the one-month Treasury rate.
- Even at the decade horizon, a minority of stocks outperformed Treasury bills.
- From the beginning of the sample or first appearance in the data through the end of the sample or delisting, and including delisting returns when appropriate, just 42.1% of common stocks had a holding period return greater than one-month Treasury bills.
- While more than 71% of individual stocks had a positive arithmetic average return over their entire life, only a minority (49.2%) of common stocks had a positive lifetime holding period return, and the median lifetime return was -3.7%. This is because of volatility and the difference in arithmetic (annual average) returns versus geometric (compound or annualized) returns. For example, if a stock loses 50% in the first year and then gains 60% in the second, it has a positive arithmetic return but has lost money (20%) and has a negative geometric return.
Bessembinder concluded that his results help to understand why active strategies, which tend to be poorly diversified, most often lead to underperformance. At the same time, he wrote that the results potentially justify a focus on less-diversified portfolios by investors who particularly value the possibility of “lottery-like” outcomes despite the knowledge that the poorly diversified portfolio will most likely underperform.
A diversified portfolio is the way to go
The results from the studies Larry has highlighted underscore the critical role of portfolio diversification. Diversification, often referred to as the only free lunch in investing, provides a sense of security and peace of mind. Unfortunately, many investors fail to fully utilize this powerful tool. They mistakenly believe that by limiting the number of stocks they hold, they can better manage their risks. In reality, a well-diversified portfolio is the key to long-term financial success.
Most professionals with PhDs in finance spend 100% of their time engaged in stock picking and have access to the world’s best databases and teams of professionals helping them. These individuals are unlikely to outperform. So why would an average investor think they have enough advantage over them? Larry’s stern advice to investors is not to play the game. His professional guidance is a beacon of reassurance in the complex world of investing, steering investors away from risky individual stocks and towards the safety of a diversified portfolio.
Investors make mistakes when they take idiosyncratic (unique), diversifiable, uncompensated risks. They do so because they are overconfident in their skills, overestimate the worth of their information, confuse the familiar with the safe, have the illusion of being in control, don’t understand how many individual stocks are needed to reduce diversifiable risks effectively, and don’t understand the difference between compensated and uncompensated risks (some risks are uncompensated because they are diversifiable).
Another likely explanation is that investors prefer skewness. They are willing to accept the high likelihood of underperformance in return for the small likelihood of owning the next Google. In other words, they like to buy lottery tickets. Larry says that if you have made any of these mistakes, you should do what all smart people do: Once they have learned that a behavior is a mistake, they correct it. So, steer away from risky individual stocks and go for the safety of a diversified portfolio.
Further reading
- Longboard Asset Management, “The Capitalism Distribution Observations of Individual Common Stock Returns, 1983 – 2006.”
- Hendrik Bessembinder, “Do Stocks Outperform Treasury Bills?” Journal of Financial Economics (September 2018).
Did you miss out on the previous chapters? Check them out:
Part I: How Markets Work: How Security Prices are Determined and Why It’s So Difficult to Outperform
- Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
- Enrich Your Future 02: How Markets Set Prices
- Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
- Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
- Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
- Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
- Enrich Your Future 07: The Value of Security Analysis
- Enrich Your Future 08: High Economic Growth Doesn’t Always Mean High Stock Market Return
- Enrich Your Future 09: The Fed Model and the Money Illusion
Part II: Strategic Portfolio Decisions
- Enrich Your Future 10: You Won’t Beat the Market Even the Best Funds Don’t
- Enrich Your Future 11: Long-Term Outperformance Is Not Always Evidence of Skill
- Enrich Your Future 12: When Confronted With a Loser’s Game Do Not Play
- Enrich Your Future 13: Past Performance Is Not a Predictor of Future Performance
- Enrich Your Future 14: Stocks Are Risky No Matter How Long the Horizon
About Larry Swedroe
Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
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Connect with Larry Swedroe
Andrew’s books
- How to Start Building Your Wealth Investing in the Stock Market
- My Worst Investment Ever
- 9 Valuation Mistakes and How to Avoid Them
- Transform Your Business with Dr.Deming’s 14 Points
Andrew’s online programs
- Valuation Master Class
- The Become a Better Investor Community
- How to Start Building Your Wealth Investing in the Stock Market
- Finance Made Ridiculously Simple
- FVMR Investing: Quantamental Investing Across the World
- Become a Great Presenter and Increase Your Influence
- Transform Your Business with Dr. Deming’s 14 Points
- Achieve Your Goals
Connect with Andrew Stotz:
Transcripts
Andrew Stotz:
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedrow, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry's unique because he understands the academic research world as well as the practical world of investing. Today we're going to discuss a recent chapter in his book, enrich your future the keys to successful investing. And the chapter is number 15, individual stocks are riskier than investors believe. Larry, take it away,
Larry Swedroe:
yeah, well, individual stock selection certainly offers the attraction of the potential for spectacular returns. Nvidia would be the latest example. Over the last few years, the returns have been spectacular. The problem with that is not only, as we discussed, that the market is highly efficient, making it difficult to identify stocks that are undervalued, okay, but most people fail to understand that individual stock selection is dramatically riskier than owning a broad selection of hundreds of 1000s of stocks, which is why diversification has been called the only free lunch and investing. So if we think about this, the stock market over the last roughly 100 years has returned, let's call it roughly 10% and the standard deviation on an annual basis of a portfolio of a broad market of stocks has been about 20% okay, what most people don't understand is that the average individual stock has a standard deviation of more than twice that. So you have, obviously, since all stocks got 10% on average, if you own stocks, you got 10% but if you own one stock or even a few, you've got twice the risk and no higher expected returns. So why do people own individual stocks? Well, one is, there's that hope of winning the lottery. And two, I think we can agree that one of the most common human traits is overconfidence. We think we can, you know, do better than the average investor. So what we hope to do here tonight is to show people how bad the odds are and why you shouldn't play that game, unless maybe you have an entertainment account. Take a couple of percent of your portfolio like you might take to a casino or a racetrack for entertainment purposes, but don't put your retirement at risk by buying individual stocks. So let's look at some of the data. There was a study done from 1983 through 2006 and it covered the top 3000 stocks. Okay. During that period, the stock market returned almost 13% per annum. The median return was just 5.1% almost 8% below the return of the market.
Andrew Stotz:
And can you explain median return for those people that may not get that
Larry Swedroe:
the mean is the average return of all the stocks. The median is half the stocks got above and half got below. So half of the stocks underperformed by almost 8% a year. Now here is the more striking thing, the average, or the mean, annualized return, was minus 1.1% so if you just randomly pick one stock, the odds would say you're more likely to get minus 1.1 now here's the way you have to think about stock buying individual stocks, The returns are not normally distributed, like they would be in a bell curve. So if we have a bell curve, and we drew a line down the middle and say the mean would be 10% you would think that half of the returns would be above 10, and half would be below 10. But we just went through an example where the mean was, sorry, the me, the average return was 12 eight, but the median return wasn't 12 eight. It wasn't even close to that. It was five, five. Okay, and. The average compound return was minus 1.1 and you get that because you get a few stocks that return 5,000% okay, so you need that. So way to think about this is, if you own the market or hundreds and 1000s of stocks, the odds are great you're going to get very close to that mean return. In that example, it was 12.8% so fewer stocks you own. Now you look more like a lottery ticket. Now the lottery ticket, the mean return, is minus 50% because the state keeps, typically half of the revenue, but most of the returns are minus 100% so if you buy one ticket, the odds are great you're going to get minus 100% is the most likely outcome, and that's the problem. The other problem we've seen, and we've talked about Henrik besenbaum this work, but he did a study, and he found that less than half of the stocks had a higher average monthly return than one month t bills. So your T bills have virtually no volatility at one month, and you got less return than that, and you're having, you know 20 sorry, you know 40 or 50 times that volatility, right? Even over a decade of a sorry, even over a horizon of a decade, a minority of stocks outperform. T bills, not the market, but treasury bills. Okay, the numbers are so compelling that you really shouldn't try. And we know, as we've discussed many times, that the typical professional investor mutual funds and they underperform after their cost. So you have to ask yourself, outside of the entertainment value, what are the odds that you're going to win that game? Which is why you shouldn't play and why more and more people are abandoning active stock selection. When I started in the business, 28 years ago, the index funds were a few percent of investment strategies. Today, we see estimates of about half of investors are now. So clearly most now we have probably getting very close the majority of investors have given up that hope and taken experience and wisdom over hope by indexing and owning broad market based strategies.
Andrew Stotz:
It reminds me of the movie Dumb and Dumber, which came out in 1994 and Jim Carrey, of course, was the lead actor, and he was infatuated with a lady in the movie named Mary Swanson, and she was played by Lauren Holly, and he was standing in front of him. Here he is this goofy, not particularly smart guy, trying to figure out if he had a chance with this woman. And the dialog goes like this, what do you think the chances are of a guy like guy like you and a girl like me, which he got confused because he's not very smart, ended up together, ending up together. And Mary says, not good. And Lloyd, Lloyd, Jim Carrey says, Not good, like one out of 100 and Mary replied, I'd say more, like one out of a million. And he replies after a long pause, so you're telling me there's a chance,
Larry Swedroe:
well, to relate that to stocks bessenbahn, that found that 100% of all the excess returns were earned by just 4% of all of the stocks. You have to look in the mirror and say, What are the odds that you can find that NVIDIA before everyone else discovers it, and it's trading, you know, with some crazy multiple already, and it's already returned the 1,000% the odds are clearly low, but it's possible. And, you know, as woody l Allen said, hope is that thing without feathers.
Andrew Stotz:
So, so this, this one kind of blows your mind, because you know what we're understanding about the market and the opportunity to pick stocks. It really blows your mind. But what, what you've explained is the way that indices are constructed, generally is going to be market capitalization weighted, and therefore, in. Index or passive funds are going to try to track that through a market capitalization weighted methodology. And in a market capitalization weighted methodology, it means that those stocks that are going up massively are going to get more weight than the tiny stocks that could go up massively. But you know, they're not going to get the weight into the index, and therefore, what I believe you're telling us is that by owning that index or passive fund, you are going to capture that average return. But if you're just trying to build a portfolio of 10 stocks or something like that, you may have diversified your portfolio, but the likelihood that you're going to catch that very time tiny percentage of really high performing return stocks is just so low that you'll always, almost always underperform the passive fund would, would that be a correct characters? Yeah,
Larry Swedroe:
that's a good way to think about and Bess and bond have found any, maybe even a more amazing statistic. And of all the stocks over the century a day that he looked at less than 1% accounted for more than half of the wealth accumulated in the month. Mean, you know, so if you think about it, the way I try to teach people to think about this, think about a bell curve, okay, and the mean is your average return. If you own the market, you're guaranteed to get that mean return. Now we don't know what it will be, unfortunately, right, could turn out in the next 10 years, we'll get 7% or 2% or 20% right. We don't know what that number will be, but whatever it is, you're guaranteed to get it. Now think about if you had a chance to own a portfolio that had a taller, thinner distribution for a bell curve. So instead of bell curve being wide, where you could get, you know, really spectacular returns, but also really awful returns. That's owning individual stocks, you have the chance, but it's weighted far more to the left, where you can get really awful returns, more likely and a low probability of getting this spectacular returns. Now if you could own the taller, thinner bell curve has the same average expected return, but you can't get you give up the opportunity to hit that home run owning the NVIDIA only, but now you eliminate the left tail risk, because stocks, on average, go up and they don't lose 100% right? Unless you happen to live in Russia, 1917 but anyway, you know, since the average investor, we know, or not just the average, the vast majority of investors are highly risk averse, the only logical strategy is to choose as the strategy the taller, thinner bell curve, getting rid of the left tail risk as the sacrifice for the small opportunity to hit the home run. And yet, half the investors today are still playing what we would call the losers game of trying to hit that home run.
Andrew Stotz:
And one last thing for me is one of my guests on episode 667, his name is Sri, and he was the one that introduced me to Besson binders research originally, and I went through it and saw it. And what he was, you know, what he saw was a great opportunity, because he said, I have the skills to find that small number. I don't need to worry about 20,000 stocks around the world. I'm just going to focus on 100 that fit the parameter. Then bring that down to the 20 or so that I'm going to hold in my portfolio. And I'm going to, you know, be able to outperform as a result of that. What would you say for the expert that's listening to this and thinking, Yeah, this, this just tells me that, you know, I'm going to use my skills to get into that little space, yeah? Well,
Larry Swedroe:
you the first thing I would say is look in the mirror and see if you see Warren Buffett. We know the vast, vast, vast majority of professionals who have PhDs in finance and spend 100% of their time engaged in this activity have access to the best databases in the world and have teams of professionals helping them, and they have been typically, highly unlikely to outperform what makes you think you have enough of an advantage over them? What advantage of any do you have over them? The answer is almost certainly none. And. Therefore you shouldn't play the game. Now it's possible you know, you have some inside information that gives you what you think is an advantage, even then, I'd be careful to think, are you really the only one who knows that? Is that not embedded already in the stock price? Perhaps not. But remember, it's also illegal to trade on that. Yeah,
Andrew Stotz:
and it just, there are some people in the markets that focus on these tiny little niches where they figure out something in this little niche that causes this particular stock to go up by 10 times. Now that stock's never, maybe ever going to be one of these super large cap stocks like Nvidia. But, you know, they, they, they went into a space where nobody you know was but that's not what we're talking about here. When you talk about these small, tiny number of stocks that are outperforming, you're talking about large cap stocks that are getting bigger and bigger and bigger. Well, once
Larry Swedroe:
they were small, and then they become large, right? And
Andrew Stotz:
when they become large is when they're having that impact. And what I'm saying is that, what's the chance that an individual sitting in Chicago has some kind of competitive advantage in a company like Nvidia? Very, very unlikely, compared to building some kind of uniqueness in a tiny little niche of the market?
Larry Swedroe:
Yeah, and, you know, look, the evidence is very clear. It's possible to win. That's what attracts people. That's what attracts people to betting on sports, even though they know. The average person you know gets taken to the cleaners, and many people end up in bankruptcy and even committing suicide because they've lost fortunes. You know, one of the worst things I you know that happens is countries legalize gambling now you got companies that are exploiting addictions that people have, and you see more bankruptcy, more credit card defaults, more mortgage defaults, because people get addicted, and they start off thinking they're smarter, better, and then they get hooked, and it's a loser. Well, the stock market is no different. They've actually run tests where they're wire your brain and people who are online trading like this, it's exactly the same part of your brain that's reacting when people are at the roulette wheel or at the slot machines or at the racetrack and they're gambling. No difference at all, but people don't recognize them.
Andrew Stotz:
A great book that I read many years ago that illustrated that was your money and your brain by Jason's
Larry Swedroe:
wife's book, yeah, excellent book, great book, by the way. Yeah.
Andrew Stotz:
Larry, I want to thank you again for another great discussion about creating, growing and protecting our wealth, and I'm looking forward to the next chapter, chapter 16. All crystal balls are cloudy. For listeners out there who want to keep up with all that Larry's doing, make sure to go to Twitter at Larry swedro, and you can find him also on LinkedIn. This is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. I.