The Risk of (Individual) Stocks

A lot of investors hold concentrated

positions in individual stocks. This can

happen when you hear Charlie Munger say,

"Diversification is for the no nothing

investor." Without realizing that he's

talking about you, or for other reasons

like being part of a company that went

public and holding on to your stock, or

owning stock in an employer that has

performed so well that it becomes a

large part of your portfolio. In any

case, I don't think people are aware of

how risky individual stocks are. In

aggregate, stocks are probably a bit

safer for long-term investors than many

people think, but individual stocks are

way riskier. And interestingly, this is

especially true for stocks that have

performed well in recent history. I'm

Ben Felix, chief investment officer at

PWL Capital, and I'm going to tell you

why holding a concentrated portfolio of

individual stocks is far more likely to

lead to catastrophic losses than to

life-changing gains.

[Music]

In this video, I'm going to detail just

how risky individual stocks are, which

is something that I suspect most

investors don't appreciate. I'll also

cover how many stocks are needed for a

portfolio to be diversified, and why

it's more than the commonly cited 20 to

30, which is a figure based on outdated

research. This is an important topic

because it is well documented that

individual investors commonly hold

portfolios concentrated in somewhere

between three and seven stocks. A

behavior that is more pronounced for

investors who overweight the unlikely

probability of a big win relative to the

more likely probability of losses. If

that's you, you're going to want to hear

me out. Individual stocks are exposed to

something called idiosyncratic risk.

That is risk specific to that company

like what its CEO happens to tweak. and

it's a type of risk that does not have a

positive expected return. In general,

investors should try to avoid

idiosyncratic risk by diversifying their

portfolios. A broadly diversified

portfolio is primarily exposed to market

risk, which is a risk with a positive

expected return. Diversification reduces

risk without reducing expected return,

which is why it is referred to as the

only free lunch in investing. If

diversification is the only free lunch

in investing, portfolio concentration is

like ordering fugu prepared by an

amateur chef. I'll define a concentrated

portfolio as a portfolio with a single

position that makes up 10% or more of

its holdings, which is a figure based on

one of the papers I'll reference later

in the video. Of course, the most

concentrated position would be holding

one individual stock, and each

individual stock after that makes the

portfolio more diversified. Concentrated

portfolios are problematic because they

allow the idiosyncratic risk, the

uncompensated or random risk of an

individual company to have a meaningful

influence on the outcome of the

portfolio as a whole. That might not be

so bad if most individual stocks

performed really well, but the data on

individual stock returns are sobering.

JP Morgan puts out an occasionally

updated report called The Agony and the

Ecstasy that details the range of

outcomes for individual stock returns.

In the 2021 issue, one of the data

points that jumps out at me is the

frequency of catastrophic losses.

Defined as a 70% decline in price from

peak to trough, which is never recovered

from. 44% of the companies that appeared

in the Russell 3000 index, an index

representing the US stock market from

1980 through 2020, experienced a

catastrophic loss. Some sectors like

energy and information technology, had

even higher frequencies of catastrophic

losses. Let me make sure that's clear

because it is staggering. 44% of the

stocks that appeared in the Russell 3000

index over this period experienced

losses of 70% or more that were never

recovered from. This shouldn't be too

surprising. Capital markets are highly

competitive and they're driven by

creative destruction. Some companies

succeed to the point that they displace

companies that had previously been

successful. And some companies fail or

at least struggle to compete. In

aggregate, stock returns are positive.

But within those positive returns are

lots of losers. Evidence of this is the

fact that despite the incredible

performance of the S&P 500 index as a

whole, hundreds of companies have been

removed from the index over time due to

business distress. The other issue is

that there are more losers than there

are winners. Over the 1980 to 2020

period, 42% of stocks included in the

Russell 3000 had negative absolute

returns. They lost money. 66% trailed

the market and 10% did beat the market

by a cumulative 500% or more over the

full period. They're deemed mega

winners. That is called positive

skewess. Most stocks perform poorly, but

a few do exceptionally well. Many of the

investors holding individual stocks are

overweighting the probability of holding

a mega winner. Some sectors are worse

for skewess than others. 84% of stocks

in the energy sector trailed the market

over this period. 85% in utilities and

73% in information technology. All of

those sectors did still have some big

winners though. Looking at the

distribution of individual stock returns

from 1980 to 2020 visually, we see that

most stocks underperform the market

while a relatively small portion of them

match or beat the market and a few do

exceptionally well. Intuitively, this

positively skewed distribution means

that if you're selecting a small number

of individual stocks for a long-term

portfolio, it's much more likely that

you will pick stocks that underperform

the market than stocks that outperform.

This is one of the reasons that

diversification makes sense in general

and why total market index funds in

particular, which hold all the stocks in

the market, are really hard to beat.

That intuition is detailed in the 2017

paper why indexing works which shows

using a simple model that when the

distribution of returns is positively

skewed randomly selecting a subset of

securities from the index may

dramatically increase the chance of

underperforming the index. This simple

model is validated empirically in the

2023 paper mutual fund performance at

long horizons which finds that the

prefee returns of only 45.2% 2% of

actively managed US equity mutual funds

in the US beat the net of fee returns of

SPY, an S&P 500 ETF over their sample

period. This shows that due to the

skewess in stock returns, active

management, which tends to hold more

concentrated portfolios than the market

index, is at a disadvantage even before

fees and costs are considered. Those

actively managed fund portfolios, while

less diversified than the market, are

much more diversified than many

individual investors. One of the reasons

for this is likely that investors

holding individual stocks think that

they know the companies that they own

and understand the risks and

opportunities that they represent. I

think this speaks to the familiarity

bias where investors are more

comfortable with what they know and the

illusion of control bias where investors

feel like they have some level of

control over the outcome of their

individual stock holdings due to their

knowledge of the company or research

they've done about investing in it. But

the reality is that the factors that

drive underperformance and catastrophic

losses are unpredictable. For example,

the JP Morgan study discusses how things

like commodity price risks that can't be

hedged away, changes in government

policy, deregulation and reeregulation

of industries, foreign competition,

trade policy, and fraud by company

employees are some of the unpredictable

things that have caused past business

failures. These are things that no

matter how well a business is run or how

well you understand it, can blindside

its profitability, leading to a

significant stock price decline or total

company collapse. These declines can

happen quickly and unexpectedly. The

2024 issue of The Agony and the Ecstasy

shows a sample of companies that

experienced catastrophic losses with the

magnitude of the loss on the y-axis and

the maximum monthly rate of decline on

the x-axis. The size of the dots

indicate the market capitalization of

the company after its decline. We see

that many companies of different sizes

have experienced huge losses that

accumulate quickly. I think it's common

for investors to want to hold on to

their losing individual stock positions

until after they have recovered, known

as the disposition effect. But in many

cases, they will continue to decline or

will simply never recover to their

previous high. It's easy to believe that

catastrophic losses can only happen to

companies with weak financials, high

valuations, or within certain sectors.

That they happen across sectors, to

profitable companies, to companies with

moderate debt ratios, and to companies

with reasonable evaluations. Any

business, even a well-run and successful

one, can suffer a catastrophic loss.

Another data point that investors may

use to evaluate whether a catastrophic

loss can happen to their stock is

analyst consensus on whether the stock

is a buy or a sell. Maybe if you only

hold on to stocks that analysts rate as

a buy, you're safe. Incredibly, the vast

majority of catastrophic losers in this

sample were consensus buys or strong

buys prior to their declines. Going back

further in time than the JP Morgan study

and extending to stocks beyond the

Russell 3000 index, the 2018 study, do

stocks outperform Treasury Bills, looks

at all US stocks that existed in the

Center for Research and Security Prices

or Crisp database from 1927 through 2016

and finds overall similar results to the

previously mentioned study. Only 42.6%

of common stocks have a lifetime buy and

hold return that exceeds the return to

holding one-mon treasury bills. This

means that more than half of the time

you are better off holding risk-free

treasury bills than individual stocks.

Only 30.8% of stocks in the sample beat

the value weighted market index, which

is what a total market index fund

represents over their lifetimes. A

figure similar to the JP Morgan study.

And more than half of the stocks in the

sample deliver negative lifetime

returns. This figure is likely worse

than the JP Morgan study due to the fact

that the sample includes all stocks,

including tiny ones, rather than being

cut off at the top 30,000 in the Russell

3000 index. And it extends to the

lifetime of stocks rather than the 1980

to 2020 sample period. The data are

slightly better at the 10-year horizon

with 49.5% of stocks beating Treasury

bills and 37.3% beating the market, but

these are still abysmal numbers

reinforcing the extreme risk of owning

individual stocks. Again, most

individual stocks are losers and some

win big. For what it's worth, the author

of Do Stocks Outperform Treasury Bills

has also co-authored a similar paper

looking at global stock returns and

found the skewess to be even more

extreme. The 2023 study,

underperformance of concentrated stock

positions, uses a set of all US stocks

excluding the smallest stocks from 1926

through 2022, similar to the Russell

3000 index to detail the effects of

concentrated positions in individual

stocks on portfolio performance. The

author finds that the median 10-year US

single stock return in this sample is a

cumulative negative 7.9 percentage

points relative to the capitalization

weighted market portfolio or an

annualized 0.82%. 82 percentage points

in underperformance and that 55% of

individual stocks trail the market at

the decade horizon. The author also

shows how the volatility of a portfolio

changes with an increasing weight in a

concentrated position by modeling

various portfolios consisting of the

market index and an increasing

allocation to an individual stock.

Portfolio volatility is relatively

unaffected by single positions at

weights up to 10%. And increasingly

affected thereafter. The effects are

more pronounced for individual stocks

with higher idiosyncratic volatility.

This is where my earlier suggestion that

a position is concentrated when it makes

up 10% or more of a portfolio comes

from. If you hear all this and think

that nobody would buy a loser stock

since smart investors only pick winners,

the crazy thing from this paper is that

stocks with top 20% performance over the

last 5 years have a median cumulative

return over the following 10 years of

negative 17.8 percentage points relative

to the market. underperforming by an

annualized 1.94 percentage points and

60% of these stocks trail the market.

Observed underperformance of the median

stock in the study applies across all

industry groups and among both the

smallest and largest stocks in the

sample. There are a few important

takeaways from these studies on

individual stock returns. Positive

skewess in individual stock returns

means that you're much more likely to

pick a loser than a winner when

selecting an individual stock. And the

effects of skewess are more extreme at

longer horizons. This means the chances

of being a successful long-term buy and

hold investor with only a few stocks is

increasingly unlikely at longer

horizons. Though, if you do pick the

rare winners, the results can be

extremely positive. Underperformance can

happen quickly, unexpectedly, and

irreversibly. Many stocks not only

underperform the market, but suffer

catastrophic losses that they do not

recover from. To be clear, it is true

that a small number of stocks perform

exceptionally well. It's just hard to

pick them before the fact. Past winners

are more likely to underperform than

outperform in the future. Given the

extreme risk and positive skewess of

individual stock returns, some level of

diversification is likely sensible. But

how much is less clear? Research from

the 1970s and 80s found that a portfolio

of 20 to 40 stocks is sufficient for

diversification because beyond that

point, the risk reduction benefits

diminish. This finding has colored the

beliefs of many investors, but it has a

problem. It assumes that volatility is

the only measure of risk that matters to

investors. I'd argue that what really

matters is the expected distribution of

long-term wealth outcomes. For example,

a more concentrated portfolio has a

small chance of holding the mega winner

and a much larger chance of holding

losers. The difference in wealth

accumulation between the worst and best

concentrated portfolios is going to be

enormous at long horizons. Reducing

volatility is a good thing, but even

small differences in volatilities can

have big impacts on long-term wealth

outcomes. A 2022 study, How many stocks

should you own? Simulates long-term

wealth multiples for portfolios with

varying levels of concentration. The

authors find the 25th and 10th

percentile outcomes, the worst outcomes,

improve dramatically until around 250

stocks are included, and the incremental

benefits of diversification decrease

thereafter. The average portfolio in

their simulations multiplied wealth 19

times on average over 25 years. But an

investor with just 25 stocks had a 1 in

10 chance of receiving less than a 12

times wealth multiple while an investor

with 250 stocks had a 1 in 10 chance of

achieving less than a 17 times multiple

of wealth. Again, the distribution of

returns is tighter for a more

diversified portfolio, meaning that the

worst outcome is less bad and the best

outcome is less good relative to a more

concentrated portfolio. This makes the

choice about how diversified a portfolio

should be a preference more than a

prescription. But I do think it's

important to highlight that when risk is

measured as the variability of terminal

wealth, the diversification benefits of

adding more stocks continues far beyond

20 to 30 holdings. If you are confident

that you can pick winning stocks before

the fact, portfolio concentration can

make sense. But the odds are stacked

against you and the track record of

active management in general leaves much

to be desired. Some investors may be

comfortable with that risk. They may be

willing to accept a wider range of

long-term outcomes, including a good

chance of trailing the market or

suffering a catastrophic loss in

exchange for a smaller chance at extreme

outperformance. This is a preference for

a lotteryike payoff, which is fine, but

it's a risk that needs to be properly

understood. In Do Stocks Outperform

Treasury Bills, the author simulates

long-term returns for 20,000 randomly

selected 5, 25, 50, and 100 stock

portfolios. He finds at the 10-year

horizon that even 100 stock portfolios

outperformed the market only 47.5% of

the time. There are different ways to

interpret that result. One way is that

hey, it was only a little worse than a

coin flip that you would have beaten the

market before costs. The other is that

you had more than a 50% chance of

trailing the market. The nice thing

about total market index funds is that

you know you're going to get the market

return even if you don't know what that

return is going to be. With a more

concentrated portfolio, you're going to

get the market return plus or minus the

active return from portfolio

concentration. The range of outcomes for

that active return will be larger with

increasing portfolio concentration. And

the distribution of outcomes will have

lots of losing portfolios and a few big

winners. Research from Vanguard shows

that fund active share, which is not the

same thing as concentration, but is

related, results in a wider dispersion

of benchmark relative returns for

actively managed portfolios. it really

becomes a question of how confident you

are that the stocks you pick will be

winners rather than losers while keeping

in mind that the distribution of

individual stock returns is kind of

scary. Another important consideration

here is that portfolio concentration may

have asymmetric effects on performance.

The 2022 paper, Fund Concentration, a

magnifier of manager skill, finds that

increasing concentration has a

pronounced positive impact on

performance for outperforming funds. But

the opposite is true for underperforming

funds. And importantly, higher levels of

concentration generally hurt the poorly

performing funds more than it helps the

outperforming funds. If you are

currently holding concentrated positions

in single stocks, there are some

economic and psychological barriers to

diversifying. The biggest economic

barrier is typically taxes. If you own a

stock that increases in value

substantially leading to concentration

in that position, there could be a large

tax bill associated with selling it. In

that case, it's important to consider

that the taxes generally don't go away.

The only thing you control is whether

you pay them now or later. Deferring

taxes can be a good thing, but in this

case, it is being traded off against

taking a large amount of idiosyncratic

risk. There are other strategies like

taxefficiently donating the appreciated

securities that can make sense, but this

decision should be approached carefully.

Another less common economic constraint

is control. Some large shareholders may

need to maintain their position in order

to maintain voting control of the

company. The psychological constraints

include the representativeness bias

where people ignore the types of base

rate probabilities that I've discussed

in this video and assume that their past

experience with a single stock is

indicative of its expected range of

future outcomes. the endowment effect

where people prefer things that they

already own. The status quo bias to

stick with the thing that they're

already doing. And in the case of a

stock that has fallen in price, the

disposition effect. Managing these

biases with respect to diversifying a

single stock position can be

challenging, but I've seen a couple

things that can help. One is imagining

that the amount you have invested in the

stock is in cash and asking yourself if

you would buy the stock today with that

cash. Another is creating a systematic

plan to dollar cost average out of the

concentrated position, avoiding the

psychological impact of one big

decision. Individual stocks are

extremely risky. Most of them

underperform the market. Many of them

have negative long-term returns or

catastrophic losses, and a small number

of them have extremely high returns.

Picking any one stock is more likely to

lead to a bad outcome than a good one.

And counterintuitively, this is even

more pronounced for stocks that have

performed well over the last five years.

The simple answer to overcoming

individual stock risk is

diversification. The extent of

diversification that makes sense depends

on your preferences for skewess, your

conviction in your stock selection

ability, and your willingness to bear

the risk of a wider range of potential

outcomes. Getting out of a single stock

position can have economic and

psychological challenges, but these can

be overcome with thoughtful planning.

Thanks for watching. I'm Ben Felix,

chief investment officer at PWL Capital.

Tell me about your single stock

positions in the comments.