The Risk of (Individual) Stocks

Summary

Ben Felix, Chief Investment Officer at PWL Capital, explains the risks of holding concentrated positions in individual stocks. He highlights the dangers of idiosyncratic risk and catastrophic losses, citing data that shows 44% of stocks in the Russell 3000 index suffered irreversible losses of 70% or more. While diversification reduces risk and increases long-term wealth outcomes, many investors are drawn to concentrated portfolios in search of big wins. Felix discusses the psychological and economic challenges of diversifying concentrated stock positions, urging investors to carefully weigh their preferences and risk tolerance before making decisions.

Takeaways

• 😀 Holding concentrated positions in individual stocks is riskier than many investors realize, and often leads to catastrophic losses.
• 😀 Diversification reduces risk without reducing expected return, and is the 'only free lunch' in investing.
• 😀 A concentrated portfolio is defined as having a single position that makes up 10% or more of the portfolio.
• 😀 44% of stocks in the Russell 3000 index experienced a catastrophic loss (70% decline from peak to trough) that was never recovered from.
• 😀 Most stocks underperform the market, and only a small percentage of stocks achieve extreme outperformance.
• 😀 The positive skewness in stock returns means that the majority of stocks lose money, but a few stocks win big.
• 😀 Actively managed portfolios tend to be less diversified than total market index funds and generally underperform due to the skewness in stock returns.
• 😀 Investors often fall prey to familiarity bias and illusion of control bias, believing they can predict the outcomes of individual stocks they know well.
• 😀 Catastrophic losses can happen to seemingly well-run companies across all sectors, not just those with high debt or poor financials.
• 😀 A more diversified portfolio (250 stocks) can reduce the range of long-term outcomes, leading to less volatility and better wealth accumulation over time.

Q & A

Why do many investors hold concentrated positions in individual stocks?

Many investors hold concentrated positions due to biases like the familiarity bias, where they feel more comfortable with stocks they know, or the illusion of control, where they believe their research or understanding of a company gives them an edge. This can also happen when someone holds stock in a company that went public or has done well, making it a large part of their portfolio.

What is idiosyncratic risk, and why is it significant for individual stocks?

Idiosyncratic risk refers to the risk specific to a company, such as management decisions or sector challenges. It's significant for individual stocks because it introduces random, uncompensated risks that can dramatically affect the performance of a stock, unlike market risk, which can offer a positive expected return through diversification.

What is the major problem with concentrated stock portfolios?

Concentrated portfolios are risky because they expose investors to idiosyncratic risk, which can result in significant losses. For example, if an investor holds too much stock in one company, a decline in that company's value can greatly affect the overall portfolio.

What did the JP Morgan study reveal about catastrophic stock losses?

The JP Morgan study showed that 44% of companies in the Russell 3000 index from 1980-2020 experienced catastrophic losses of 70% or more, which were never recovered. This highlights the high probability of major losses within concentrated stock positions.

What is positive skewness in stock returns, and why does it matter?

Positive skewness in stock returns means that while most stocks underperform, a few outperform the market by a significant margin. This creates a situation where investors are more likely to pick losers than winners, making concentrated portfolios riskier and harder to manage for long-term success.

How does diversification mitigate risk in investing?

Diversification spreads risk across different stocks or asset classes, reducing the impact of any single poor-performing investment. It ensures that a portfolio isn't overly reliant on the success or failure of one company, which lowers the chance of catastrophic losses.

Why is it challenging to pick winning individual stocks?

It's challenging because, despite past performance, many individual stocks that performed well are more likely to underperform in the future. The unpredictability of factors affecting stock performance, such as market conditions, policy changes, or internal company issues, makes it difficult to reliably choose winning stocks.

What is the downside of actively managed funds with concentrated stock positions?

Actively managed funds often hold more concentrated positions than a market index, which increases the volatility and risk. While these funds have the potential for higher returns, they also face a higher likelihood of poor performance due to the randomness of individual stock performance.

How can psychological biases impact decision-making in concentrated stock positions?

Psychological biases like the representativeness bias (assuming past performance predicts future outcomes), the endowment effect (favoring stocks already owned), and the disposition effect (holding onto losing stocks in the hope they’ll recover) can lead to poor decision-making, making it difficult for investors to diversify or sell concentrated positions.

How can investors overcome the economic and psychological barriers to diversification?

Investors can overcome these barriers by imagining that their concentrated stock positions are in cash and asking whether they would buy those stocks today. They can also implement a systematic plan, like dollar-cost averaging out of the concentrated position, to avoid the emotional impact of making a single, large decision.