Investing in the stock market can seem confusing, especially when deciding whether to buy individual stocks or use a more passive or index-based approach. Recent research by Hendrik Bessembinder, explained by Larry Swedroe in his article “Owning Individual Stocks: A Loser’s Game,” shows why owning individual stocks might not be smart for most people.

The Truth About Individual Stocks 

One of the most surprising findings from Bessembinder is that most individual stocks cause shareholders to lose money.

His study, which looked at the performance of U.S. stocks from 1926 to 2019, found that:

• Most stocks led to reduced shareholder wealth.
• Stock market wealth is concentrated in a few top stocks: Just 86 top-performing stocks, less than one-third of 1% of the total, made up more than half of the wealth creation.
• The top 1,000 performing stocks, less than 4% of the total, accounted for all the wealth creation, while the remaining 96% of stocks only matched the returns of risk-free one-month Treasury bills.

Understanding Why Most Stocks Underperform 

The concept of positive skewness in stock returns helps explain why most individual stocks don’t perform well. In a positively skewed distribution, most individual outcomes are below the average, meaning:

• Portfolios are more likely to underperform the overall market.
• Wealth creation has become even more concentrated in a few top-performing stocks.

Lifespan and Performance of Stocks 

Bessembinder’s latest research, covering 1926-2023, further highlights how short-lived most stocks are:

• The average company is listed in the CRSP database for only 11.6 years, with a median lifespan of just 6.8 years. The CRSP (Center for Research in Security Prices) database is a collection of historical data on securities traded in U.S. markets, including stocks, bonds, and mutual funds.
• Over half of the stocks (51.6%) had negative cumulative returns, with a median outcome of -7.41% per year.
• Even among the stocks with the highest cumulative returns, the median annualized return was relatively modest.

The Investor’s Challenge 

The findings highlight the significant risks associated with owning individual stocks, which are not compensated by higher returns. Diversifying investments across a broad index can mitigate these risks without lowering expected returns. However, many investors continue to pick individual stocks due to several psychological and cognitive biases:

1. Overconfidence in Their Skills: Investors often believe they have superior stock-picking abilities, leading them to overestimate their chances of success.
2. Overestimation of Their Information’s Value: Many investors think they possess unique or valuable information that gives them an edge, even when the information may be widely known or irrelevant.
3. Confusing the Familiar with the Safe: Investors tend to favour familiar companies or industries, mistakenly believing that familiarity equates to safety and lower risk.
4. Illusions of Control: This bias leads investors to feel they can influence or control outcomes in the stock market through their actions or decisions, which is typically not the case.
5. Lack of Understanding of Diversifiable Risks: Many investors do not fully grasp that some risks can be eliminated through diversification, and by holding individual stocks, they are exposing themselves to unnecessary risk.
6. Preference for Positive Skewness: Similar to buying lottery tickets, some investors are attracted to the slim chance of achieving extremely high returns from individual stocks, even though the probabilities and risks are high.

The Path to Better Investing 

The historical record suggests that wealth creation in the stock market will continue to be concentrated in relatively few firms. Active management and security selection are unlikely to benefit from this concentration consistently. Instead, the winning strategy is to avoid active security selection and market timing and instead focus on the power of diversified, low-cost investment strategies.

If you find yourself making common investment mistakes, now is the time to learn from them and correct your behaviour. Embracing diversification and understanding the nature of market returns can set you on the path to more reliable and rewarding investment outcomes. By integrating these insights into your investment approach, you can avoid the pitfalls of owning individual stocks and steer towards a more secure financial future. Remember, smart investing is about minimizing risks and maximizing the potential for long-term growth through prudent diversification.

References 

Swedroe, Larry. “Owning Individual Stocks: A Loser’s Game.” FA Online, August 1, 2024.

Bessembinder, Hendrik. “Wealth Creation in the US Public Stock Markets 1926-2019.” 2021.

Bessembinder, Hendrik. “Which U.S. Stocks Generated the Highest Long-Term Returns?” July 2024.