For the vast majority of individual investors, investing in individual stocks, as opposed to mutual funds or ETFs, is a losing strategy. This assertion is based on financial theory and vast amounts of empirical evidence. Unfortunately, most of my own experience also is consistent with this assertion.
When you invest in the stock of a single company, you are taking the unnecessary risk that the company will perform poorly relative to its competitors, causing the value of the stock to decline. This risk is unnecessary because it can be diversified away by investing in stocks of more than one company. In financial terms, specific company risk is known as unsystematic risk. Since unsystematic risk can be eliminated through appropriate diversification, there is no rational reason to take this type of risk (unless you are an extremely gifted business analyst like Warren Buffet).
Similarly, by buying stocks of many companies in a single industry you diversify away the company-specific risk, but you still are exposed to the risks of that industry. For example, if you invest only in the stocks of energy companies like Exxon-Mobil, Chevron and Royal Dutch Shell (not to mention BP), and the energy industry does poorly, your investment performance will suffer. This is why we should diversify among many industries.
Much academic research has been done to support the notion that one should diversify broadly among many stocks in many industries. Modern Portfolio Theory, first developed in 1952 and expanded greatly since then, is the theoretical foundation that supports this.
In addition to the theory, many studies have been done that support the importance of broad diversification among stocks. One interesting study, discussed in an article written by William Bernstein, found that most stocks lose money over time. Specifically, from 1980 to 2008, the top performing 25% of stocks were responsible for all the gains in the broad US stock market. The bottom 75% of stocks generated annual losses of about 2% over that 29 year period. Even if you owned 90% of all stocks, but not the top 10%, you would have ended up with about 1/3 as much at the end of the 29 year period (compared to investing in the broad market). If you own only the stocks of a few companies, the odds are that you’ll end up with more losers than winners. You can easily miss out on the top 10%, which is likely to have a dramatic negative effect on your investment returns. If you believe you can pick mostly stocks that will be in the top 10% or even the top 25%, then you probably aren’t aware of the vast amount of research that has shown the extreme difficulty of doing so.
Unfortunately, my personal experience is consistent with the theory and empirical evidence. I’ve bought and sold many individual stocks during my 40 years of investing, and in general, it’s been a losing proposition. For example, I invested with a full service (i.e., expensive) broker between January 1991 and February 1999, primarily buying and selling stocks and options based on his recommendations. Although there were ups and downs along the way, (in my best year I made about $33,000 and in my worst year I lost about the same amount) after those 8 years, I had a net loss of about $7,000 (not factoring in inflation). You know who made money though? That’s right – the broker.
By comparison, the Vanguard 500 Index fund increased in value by about 300% (quadrupled in value) during the same 8 years. I select this fund for comparison because it is a broad-based US stock market index fund (it seeks to track the S&P 500) that existed in 1991 (and that I probably would have invested in if I knew what I know now).
Now, to paint a fair picture, I did invest in HP stock through employee stock purchases during this same time period, and HP stock increased by about 800% (9 times) in those 8 years. However, I can’t emphasize strongly enough that this was luck, not skill. I just happened to be working for a company that did very well during this particular period.
HP stock went on to increase to about 13 times its 1991 value at the peak of the bull market in early 2000, but then fell to about 2.4 times its 1991 value at the bottom of the bear market in late 2002; this is about the same as I would’ve done in the Vanguard 500 Index fund between 1991 and 2002.
Note that if you had invested in HP stock in April of 2000 and sold in September of 2002, you would’ve lost over 80% (leaving you with only 1/5 of your original investment), while the S&P 500 lost “only” about 40% (at least leaving you with more than 1/2 of your original investment).
The HP stock examples above show that you can be very lucky with one stock, but also very unlucky, even with the same stock but during different time periods. Again, if you think you or your broker can consistently pick the right stocks and the right times to buy and sell, you either or not aware of the research showing how extremely unlikely this is, or you are overconfident in your abilities (or those of your broker) to pick stocks and time the market. If you invest in individual stocks, which I wouldn’t recommend for most people, please limit the amount to a very small percentage of your investment portfolio.
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