The stock portfolios I build for my clients consist of thousands of companies around the world. I don’t pick individual stocks, nor do I recommend this to anyone who asks my opinion. But every so often I hear from a client who wants to include individual companies in his portfolio, and I have to explain why this isn’t a good idea.
I can understand why people want to do this: choosing individual stocks offers the promise of dramatically outperforming the market. But that’s only half the story. As William Bernstein writes in The Four Pillars of Investing: “Concentrating your portfolio in a few stocks maximizes your chances of getting rich. Unfortunately, it also maximizes your chance of becoming poor.”
Here’s why: stock market returns in any given period are driven by a relatively small number of companies or sectors. If you don’t have those stocks in your portfolio at the right time, you can easily miss out on enormous opportunities. Bernstein, for example, looked at 2,615 U.S. stocks in the Morningstar database and found that only 885 of them (almost exactly a third) posted returns higher than the S&P 500 over the 10-year period he examined. In other words, two out of every three randomly selected stocks would have underperformed the market. And about 19% of the companies lost money over the decade—not including those that went bankrupt and were removed from the database.
Of course, stock pickers don’t choose at random: rather, they analyze the stock’s fundamentals to identify companies they think will outperform. Sometimes they’re right—but what is the price of being wrong? Consider that the U.S. market as a whole returned 9.6% annualized from 1926 through 2009. However, if you exclude the best performing 10% of stocks in each year, that annualized return would have shrunk to 6.2%. If you remove the top 25% of performers in each year, the annualized return would have been –0.6%*.
Think carefully about those numbers. During a period of more than eight decades, the top 25% of performers in each year—and remember, these big winners change annually—meant the difference between outstanding returns and an outright loss. If you are building a portfolio with 20 or 30 stocks from the universe of thousands, how likely are you to own those in the top 25% year after year?
The Gambler’s Curse
The math says that your chances of outperforming the market by picking stocks is remote—or in gambling terms, “a long shot.” So why do people ignore these probabilities?
I recently spoke with a performance psychologist who lives just outside of Las Vegas of all places, who shed some light on the subject. She explained that if you go to a casino, an early winning streak is actually a curse. When you sit down at a poker table and win the first couple of pots, you can easily get the impression that you are a skilled player, even though your performance probably has more to do with luck. Eventually, the cards stop falling your way and all your chips are soon gone.
The same pattern can occur with stock picking: many people enjoy early success, especially if they start investing during a bull market. They attribute their success to skill, even though short-term performance in stock picking is almost always random. Encouraged by their initial success, they make bolder and bolder picks until the market ends up eating them for lunch. In both gambling and investing, probability eventually catches up with everyone.
At some point, you need to ask yourself why you are investing in the first place. “You can have two possible goals,” Bernstein writes. “One is to maximize your chances of getting rich. The other is to minimize your odds of failing to meet your goals or, more bluntly, to make the likelihood of dying poor as low as possible. It’s important for all investors to realize that these two goals are mutually exclusive.”
Stock pickers, like gamblers, are choosing the first goal: the possibility of riches makes them ignore the more likely outcomes. Wise investors, on the other hand, make a conscious decision to put the probabilities in their favour.
* Results based on the CRSP 1-10 Index. CRSP data provided by the Center for Research in Security Prices, University of Chicago.