It often pays to concentrate. For example, when you check out my Common Sense Investing series, I’d love to have your undivided attention. The same could be said when you tune into our new Rational Reminder podcast channel, co-hosted by me and PWL colleague Cameron Passmore.
But sometimes, concentration is overrated. A prime example is concentrated stock positions, which you can learn more about here or in my related video, below.
If you’re hoping I’m going to tell you how to successfully pick winning stocks, you might as well shift your attention elsewhere. Instead, I’m going to show you the evidence on just how risky it is to even try. I’ll also cover why so many people keep trying anyway, instead of just investing in low-cost, globally diversified index funds.
Today’s conversation begins with a discussion on systematic vs. non-systematic investment risk. Here’s what the evidence tells us about each:
Even once we know it is not sensible to own individual stocks, most of us are tempted to scratch the itch to speculate a bit anyway, irrationally holding large, concentrated positions in single securities. It’s an itch driven by a handful of behavioral biases that are hard to spot and even harder to overcome.
I get it. I have seen people get rich quickly by piling into crazy ventures like bitcoin, tech stocks, and cannabis stocks. Just as we all may know somebody who has struck it rich through random good fortune, we all probably know at least a few people who have made real money by picking stocks.
These random tales of success are dangerous, because they tempt us to wonder whether we might be able to get lucky too.
What are your odds? I’ll take a closer look at that in a moment. For now, assume if you or someone you know is a successful stock-picking speculator, it should almost certainly be attributed to luck.
The problem is, our inherent behavioral biases convince us otherwise. They mess with our higher reasoning, until occasional luck starts to feel like a repeatable skill. I encourage you to check out my accompanying video for more detailed insights, but here’s an overview:
Confirmation bias: People attribute the random outcome of a stock going up to their prior belief (or hope) that it would. Think of it as the “I thought so” bias.
Familiarity bias: It is extremely easy to confuse familiarity with safety. In the stock market, they’re not only unrelated, they’ve never even met one another. And yet, familiarity is probably why so many employees are willing to hold concentrated positions in their company’s stock. Whether you’ve acquired it through a compensation package or you’ve bought it on the open market, your own employer’s stock is about as familiar as it gets. But that doesn’t mean it’s any safer.
Overconfidence and Illusion of Control: Continuing the theme of holding company stock, any investor is exhibiting overconfidence when they hold a concentrated position in any individual stock. But overconfidence is likely to kick into overdrive when that position is in your employer’s stock. Not only do you believe in the company, but you feel you know it well, and have an impact on its future success. This illusion of control makes it really, really hard to understand that your thoughts, feelings and hard work may help your company thrive, but they have little to do with its share price. The share price is driven by all sorts of factors, the vast majority of which are beyond your control.
Illusion of control isn’t just for employees, by the way. If you have put a lot of time and effort into researching a trade, you may feel you have more control over the outcome. This is irrational, although confirmation bias will convince you otherwise if you do happen to “win.”
Endowment Effect: As if these biases weren’t enough, investors also tend to overvalue assets they already own. This “endowment effect” makes you less willing to part with an asset you own, even if you would not buy it at its current price. A good way to check for endowment effect is to ask yourself: “If I had the value of these shares in cash, would I buy them today?” Framed this way, most people can make a more sensible choice on whether to continue to hold them.
For better or worse, we humans are an optimistic sort. That is, even when we know it may not be entirely rational, we tend to overweight the likelihood of generally positive outcomes, and underweight the possibility of extremely negative outcomes. What’s an “extremely negative outcome” in the stock market? Nortel, Enron, Lehman Brothers, Bear Stearns … to name a few.
I agree, total losses are relatively rare. It’s more likely stock-picking investors will simply underperform the market over time.
As evidence, in May 2018, Hendrik Bessembinder of Arizona State University published a paper, Do Stocks Outperform Treasury Bills? In it, he demonstrated that the vast majority of stocks since 1926 have had lifetime buy-and-hold returns that were less than one-month Treasury yields. For his source, he used stocks from the Center for Research in Security Prices (CRSP) database, a comprehensive database of US stocks. In other words, Bessembinder found you would have been better off taking no risk with your capital than investing in most individual stocks.
What did “most” mean in this study? It meant that the best performing 4% of listed companies explained the returns for the entire US stock market since 1926. The remaining 96% of stocks collectively matched the return of Treasury bills. By consistently holding the market rather than trying to pick its best stocks, you could still earn a decent return. If your risk tolerance was sufficient to tilt toward some of the market’s riskier sources of expected returns – such as small-cap or value stocks – you could potentially earn a little more, But your odds of outperforming by trying to pile into just those few winning stocks and avoid the many underperformers? Pretty low. Really low, in fact.
Others have conducted similar studies assessing particular sources of return, specific sectors, and various market conditions. I hope you’ll view my video, where I cover these in more detail and offer links to the sources.
Bottom line, the data only gets worse. It does not support what most people probably have in mind when they buy or hold an individual stock. It’s easy to be blinded by the glamor of all of the money you hope you’re going to make. You may even understand it is a risky bet. But if you haven’t taken a hard look at the evidence – and gotten past our many behavioral biases – you are highly likely to underestimate just how risky it is to take a concentrated stock position, and how badly the odds are stacked against you. Historically, you are far more likely to pick a loser than a winner. And that loser is far more likely to not only trail the index, but to have negative absolute returns.
Are you still tempted to hold positions in individual stocks? Do me a favor, and at least limit your positions to some “mad money” you can afford to lose. Win or lose, I hope you’ll share your experiences with us in my video comments.
One more thing before I sign off. If you enjoy my Common Sense Investing series, don’t forget to tune into our new Rational Reminder podcast available on Libsyn, Itunes, Google Play, Spotify and Stitcher. It’s one more way we hope to spread some common sense on rational investing.
