The Risk of (Individual) Stocks

Key Concepts

• Idiosyncratic Risk: Risk specific to an individual company, such as management decisions or operational issues, which does not have a positive expected return.
• Market Risk: Risk associated with the overall market, which has a positive expected return.
• Diversification: The strategy of spreading investments across various assets to reduce risk without sacrificing expected returns.
• Concentrated Portfolio: A portfolio where a single position constitutes 10% or more of its holdings.
• Catastrophic Loss: A decline in stock price of 70% or more from peak to trough, with no recovery.
• Positive Skewness: A distribution of returns where most outcomes are poor, but a few are exceptionally good.
• Familiarity Bias: The tendency for investors to favor investments they are familiar with.
• Illusion of Control Bias: The belief that one has more control over investment outcomes than is actually the case.
• Disposition Effect: The tendency to hold onto losing investments too long and sell winning investments too soon.
• Representativeness Bias: Ignoring base rate probabilities and assuming past experience with a stock indicates its future performance.
• Endowment Effect: Preferring things one already owns.
• Status Quo Bias: Sticking with current actions or decisions.

The Risks of Concentrated Stock Portfolios

This video details the significant risks associated with holding concentrated portfolios of individual stocks, arguing that such strategies are far more likely to lead to catastrophic losses than life-changing gains. The presenter, Ben Felix, Chief Investment Officer at PWL Capital, emphasizes that most investors underestimate the inherent risk of individual stocks, especially those that have performed well recently.

Understanding Idiosyncratic vs. Market Risk

Individual stocks are exposed to idiosyncratic risk, which is company-specific and does not offer a positive expected return. Investors are advised to avoid this risk through diversification. A broadly diversified portfolio, conversely, is primarily exposed to market risk, which has a positive expected return. Diversification is described as "the only free lunch in investing" because it reduces risk without reducing expected return. Portfolio concentration, in contrast, is likened to "ordering fugu prepared by an amateur chef."

A concentrated portfolio is defined as one where a single position makes up 10% or more of its holdings. This allows idiosyncratic risk to significantly influence portfolio outcomes.

The Sobering Data on Individual Stock Returns

Data from JP Morgan's "The Agony and the Ecstasy" report highlights the frequency of catastrophic losses. Between 1980 and 2020, 44% of companies in the Russell 3000 index experienced a catastrophic loss (a 70% decline from peak to trough that was never recovered). Some sectors, like energy and information technology, saw even higher frequencies. This phenomenon is attributed to the competitive nature of capital markets and creative destruction, where successful companies displace older ones, and others fail.

Further analysis of the 1980-2020 period reveals:

• 42% of stocks in the Russell 3000 had negative absolute returns.
• 66% trailed the market.
• Only 10% beat the market by a cumulative 500% or more, termed "mega winners."

This distribution of returns exhibits positive skewness, meaning most stocks perform poorly, but a few achieve exceptional success. Investors holding individual stocks often overweight the probability of picking a mega winner. Sectors like energy (84% trailing the market), utilities (85%), and information technology (73%) showed particularly poor performance relative to the market, though all still had some significant winners.

The Impact of Skewness on Portfolio Selection

The positively skewed distribution of individual stock returns implies that selecting a small number of stocks for a long-term portfolio makes it much more likely to pick underperformers than outperformers. This supports the rationale behind indexing, particularly total market index funds.

Research, such as the 2017 paper "Why Indexing Works," demonstrates that randomly selecting a subset of securities from a positively skewed distribution can dramatically increase the chance of underperforming the index. This is empirically supported by the 2023 paper "Mutual Fund Performance at Long Horizons," which found that only 45.2% of actively managed US equity mutual funds beat the net-of-fee returns of the S&P 500 ETF (SPY) over their sample period. This disadvantage exists even before fees, as actively managed funds, while more diversified than individual investors, tend to hold more concentrated portfolios than market indexes.

Psychological Biases and Unpredictable Risks

Investors often believe they understand the companies they own, leading to familiarity bias and the illusion of control bias. However, the factors driving underperformance and catastrophic losses are often unpredictable. These include commodity price risks, changes in government policy, foreign competition, trade policy, and even fraud. These factors can blindsight profitability and lead to significant stock price declines or company collapse, regardless of how well a business is run or understood.

The 2024 issue of "The Agony and the Ecstasy" visually demonstrates that catastrophic losses can occur quickly and unexpectedly across companies of various sizes and financial health. The disposition effect can lead investors to hold onto losing positions, hoping for recovery, which often never materializes. Catastrophic losses are not limited to companies with weak financials or high valuations; they can affect profitable companies with reasonable debt and valuations. Even stocks rated as "buy" or "strong buy" by analysts have experienced catastrophic declines.

Long-Term Performance Data

Extending the analysis beyond the JP Morgan study, the 2018 paper "Do Stocks Outperform Treasury Bills" examined all US stocks from 1927 to 2016. Key findings include:

• Only 42.6% of common stocks had a lifetime buy-and-hold return exceeding one-month Treasury bills, meaning more than half the time, holding risk-free T-bills was better.
• Only 30.8% of stocks beat the value-weighted market index.
• More than half of the stocks delivered negative lifetime returns.

These numbers are likely worse than the JP Morgan study due to the inclusion of all stocks, including very small ones, and the longer time horizon. Even at a 10-year horizon, only 49.5% of stocks beat Treasury bills and 37.3% beat the market, indicating abysmal performance for individual stocks. The skewness is even more extreme in global stock markets.

The 2023 study, "Underperformance of Concentrated Stock Positions," analyzed US stocks from 1926 to 2022. It found that the median 10-year US single stock return underperformed the market by 7.9 percentage points cumulatively (0.82% annualized), with 55% of individual stocks trailing the market over a decade.

Portfolio Volatility and Concentration

The volatility of a portfolio increases significantly with concentrated positions exceeding 10%. This effect is more pronounced for stocks with higher idiosyncratic volatility. Interestingly, stocks with top 20% performance over the last 5 years had a median cumulative return over the following 10 years of negative 17.8 percentage points relative to the market, with 60% of these stocks trailing the market. This highlights that past winners are not guaranteed future outperformers.

How Much Diversification is Needed?

While diversification is crucial, the optimal number of stocks is debated. Older research from the 1970s and 80s suggested 20-40 stocks were sufficient, but this was based solely on volatility reduction. A 2022 study, "How Many Stocks Should You Own?", simulated long-term wealth multiples and found that the worst outcomes (25th and 10th percentile) improved dramatically up to around 250 stocks, with diminishing incremental benefits thereafter. While the average portfolio multiplied wealth 19 times over 25 years, an investor with 25 stocks had a 1 in 10 chance of less than a 12x multiple, compared to a 1 in 10 chance of less than a 17x multiple for an investor with 250 stocks. This suggests that when risk is measured by the variability of terminal wealth, diversification benefits extend far beyond 20-30 holdings.

The choice of diversification level is a preference, influenced by one's conviction in stock selection and tolerance for a wider range of outcomes. Holding concentrated positions can be seen as a preference for a lottery-like payoff, which is acceptable if the risks are understood. Even 100-stock portfolios, in simulations, outperformed the market only 47.5% of the time at the 10-year horizon. Total market index funds guarantee market returns, whereas concentrated portfolios add active return (positive or negative) from concentration.

Asymmetric Effects of Concentration

Research indicates that portfolio concentration can have asymmetric effects on performance. For outperforming funds, increased concentration has a positive impact, but for underperforming funds, it generally has a negative impact, hurting them more than it helps the outperformers.

Barriers to Diversification

Economic barriers to diversifying concentrated positions include taxes on capital gains. While deferring taxes is an option, it means continuing to bear significant idiosyncratic risk. Tax-efficient strategies like donating appreciated securities can be considered. Another constraint can be the need to maintain control of a company through a large shareholding.

Psychological barriers include:

• Representativeness bias: Ignoring base rates and assuming past stock performance predicts future outcomes.
• Endowment effect: Preferring what one already owns.
• Status quo bias: Sticking with current actions.
• Disposition effect: Holding onto losing stocks.

Strategies to overcome these biases include imagining the invested amount as cash and asking if one would buy the stock today, or creating a systematic plan to dollar-cost average out of the concentrated position.

Conclusion

Individual stocks are extremely risky, with most underperforming the market, many experiencing negative long-term returns or catastrophic losses, and a few achieving extremely high returns. Picking any single stock is more likely to lead to a bad outcome. Diversification is the simple answer to overcoming individual stock risk. The appropriate level of diversification depends on individual preferences for skewness, conviction in stock selection, and risk tolerance. While economic and psychological challenges exist in diversifying concentrated positions, they can be managed with thoughtful planning.