Stock Ticker Tape

There are three main reasons why I generally recommend to stay away from individual stock picking:

  • First, you may get lucky with a few stock picks – but are you or your financial advisor really professional stock pickers, or just hobbyists? This is important because we’re talking about long-term investing, and will the stocks that you picked 15 years ago still be able to out-perform the benchmark stock indices going forward?  If not, do you have the expertise to be able to pick replacements for them, say 10 to 20 years from now?
  • Any one company stock that you pick can go bankrupt – which means that its stock can go to zero, thus making you lose everything you invested in it. The more individual stocks you have in your portfolio, the less impact a bankruptcy or severe pullback in the stock price will have on your portfolio.  Many studies show that investors need at least 30-50 stocks (across various industries – not overly concentrated in technology or pharma, for example), to reduce the risk of a stock portfolio sufficiently to the point where it approaches the risk of the overall market.  Here is such a study, done by Deutsche Bank – Kleinwort Benson:

Diversification Stock Portfolios

In the chart above, notice that the risk of the overall stock market is around 15%.  This is in terms of the annualized standard deviation and/or the implied volatility (the options market measure of risk) of the portfolio.  Standard deviation and implied volatility are two commonly used ways to gauge the volatility (or excited-ness) of the stock price. Biotech stocks, for instance, exhibit notoriously reckless price movement – they really fly around the place. It’s not uncommon for biotech stocks to have annualized standard deviations as high as 90% – as much as 6 or 7 times the risk of the overall market!

Last check, Warren Buffett’s stock portfolio has 46 companies in it, but most of Berkshire Hathaway’s funds are allocated to 20 names. If you’re interested in investing in Buffett’s fund, the ticker is BRKB.

But even Warren Buffett has suffered tremendous drawdowns in his stock (and bond) portfolios.

Warren Buffett Suffered 50 Percent Drawdown

It wasn’t until April 2013 that the fund managed to regain its losses.  Many individual investors also got burned during this market correction.  Many also suffered by losing their lives – the stress and anxiety was just too great for many – causing cardiac arrests and even suicides.

From my experience, any investor or trader who loses 50% in any given year is likely to lose his job.  I’m not putting Buffett down here – just saying that the volatility of stock investing can be devastating – and just as importantly, most individuals do not have the mental or financial fortitude to handle such stress.

While the financial meltdown of 2008-2009 was pretty bad, it pales in comparison to the Great Depression.

That means that if you bought $100K of stocks at the start of 1928, by December 1932 your portfolio would have been worth only $15K. One can only imagine the degree of carnage and devastation back then.  The stock market did of course come back, but took 7 years to recover (by the end of 1935, investors who were still alive managed to regain what was lost during the Great Depression).

Great Depression Drawdown Stock Market

Bottom line is that if you want to pick individual stocks, you better have at least 30 stocks in your portfolio –which also assumes that you have sufficient capital, the expertise, the time and energy to manage them.

  • The third reason to opt for a stock fund over picking individual stocks has to do with something called survivorship bias. This applies particularly to index funds that replicate the composition of a benchmark – such as SPY (the SPDR ETF) and VFINX (both S&P 500 indices), the mid-cap MDY ETF, QQQ (Nasdaq 100), the IWM small-cap index – or any of the major cash indices comprised of stocks.  All the major index companies – Standard & Poors, MSCI, Russell, iShares etc. have certain criteria that must be met by companies that comprise the index. These criteria include liquidity hurdles (a minimum number of shares traded per day), a minimum stock price, and in some cases certain fundamental/financial standards.  Companies that don’t meet these criteria get dropped from the index. What this means is that companies that are bound to go bankrupt get dropped from the index, which in turn means that only solvent, competitive companies stay in.

This in itself is a powerful reason never to pick individual stocks.

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