Successful Investors Avoid Picking Individual Stocks
One of the most dangerous temptations for investors is the potential for buying the next big hit stock, a stock that will grow at supersonic speed, far in excess of the overall market’s growth.
The hunt for the next Microsoft (a few generations ago it was the search for the next IBM) has probably been responsible for more wealth destruction than any other investment fallacy.
Consider this:
- Although the U.S. stock market has survived periodic crises and thrived over time, the majority of stocks that make up the market vanish in any 10-year period, to be replaced by new stocks.
- Although successful investing is a long-term game, buying individual stocks shortens an investor’s time horizon, forcing more decisions and increasing the risk of a bad decision.
- Using intuition or analytical skills to pick a stock often does not work because our intuition leads us to growth stories, while the market leaders year-to-year are often the counter-intuitive losers, the so-called value stocks.
Irresponsible Investing
Much evidence exists to show that individual stock investing loses out to diversified market investing. Investors who ignore that evidence should be considered irresponsible, gambling with their own money or with the legacies they intend to leave to loved ones.
In the short-term, investing in a broad basket of stocks that resembles the market and investing in one or two individual stocks may have equal chances of success or failure. In fact, buying the “right” individual stock in this scenario may give the individual investor a slight advantage of beating the market.
But studies have shown that over longer periods of time the diversified market investor has a much better chance of beating the individual stock investor.
One doesn’t need a statistical analysis to guess that result: since individual stocks can and do have larger declines than the overall market—or may cease to exist altogether—a certain percentage of individual stock investors are guaranteed a much worse experience than the market.
Consider the bear market of 2008, when a diversified market investor lost 37 percent or more in American stocks. Yet individual stock investors who had been enjoying years of outstanding returns in some financial stocks like insurer AIG, Washington Mutual Savings Bank, or mortgage company Fannie Mae saw their investments sink nearly to zero. Meanwhile, investors in Lehman Brothers did see their holdings vanish.
Diversified wins out
One study by Dimensional Fund Advisors, a California-based investment company, simulated returns on a concentrated stock portfolio and a diversified market portfolio over a 25-year period.
It found that the majority of potential diversified returns far outpaced the potential concentrated stock returns. The worst 5 percent of cases saw the market portfolio nearly double, while the worst concentrated stock returns resulted in a loss of 91 percent.