The Risks of Investing in Individual Stocks
When my wife and I began investing, we did what is probably the most common thing that Canadians do, we went to our local bank branch, sat down with a financial advisor, and invested in a portfolio of mutual funds issued by that bank. We scheduled regular contributions and kept at it for several years.
Later, as our portfolio grew, we switched to an investment advisor (IA) at an investment firm, a subsidiary of the same bank. At that point, we were no longer bound to the bank’s branded funds; our IA recommended – and we agreed – that we invest in a variety of mutual funds from different issuers. As time marched on, and as I learned more about the investing world, I raised the subject of investing in individual stocks. In particular, I was interested in stocks that paid dividends. I had learned that dividends were an indicator of good quality investments.
Eventually, however, as I continued my study of investing – I had joined the investment industry by that time and had also transferred our advised accounts to the self-directed investing division of the same firm – I learned two things: 1. That there was a degree of risk in individual stocks that I no longer wanted to take on; and 2. That a diversified portfolio of low-cost mutual funds or ETFs can result in investment returns that are nearly equal to the market return less a relatively minor expense.
People Still Want to Hit that Home Run
In the last half-century or so, a lot has been learned about the nature of the stock market and the varieties of financial risk one can encounter during the course of one’s investing career. Nevertheless, there are still many people who view the stock market as a kind of lottery. “I’m going to put my money down on ABC stock.” This is not an isolated incident. I have seen many such accounts, one person even telling me that his entire life savings had gone into one particular stock.
“I Agree. One Stock is Too Risky. That’s why I Own Ten.”
If you agree that owning one stock is too risky, how about diversifying across several stocks? That sounds good, but how much diversification is necessary to reduce your risk? Will the stocks of ten different companies do the job? If not, how many? Furthermore, just because you own the shares of several different companies, are you still truly diversified?
Diversifying Within the Same Industry
At the end of 2017 and the beginning of 2018, as the legalization of cannabis was approaching, an incredible amount of interest was being shown by individual investors. There was a huge rush to open new accounts, which inevitably led to delays of weeks before they were actually opened. As people began investing, I noticed a trend. Many would hold several stock positions in their accounts, but they were all of different companies within the cannabis industry, which means they were all subject to the same industry-specific risk.
When I was getting started in the investment industry, a fairly common rule of thumb suggested that 20 – 25 different companies would be adequate diversification to eliminate most of the risks of an overly concentrated investment portfolio. That number has steadily been pushed higher such that there are portfolio managers who will argue that shares in 100 companies or more are required to adequately reduce the specific or unsystematic risk of individual stocks.
The problem is, to get to that degree of diversification, you must buy the shares of those companies. First, are you able to perform adequate research on all the stocks you want to buy? Are you able to research the various sectors that make up a truly diversified portfolio? Second, once purchased, will you be able to keep up on the latest news about each of the companies? If you are working full-time at your regular job, do you even have the time?
Variation: Diversifying Only Within Canada
Home bias is common in Canada as it is in many other corners of the investing world. Home bias means you invest a disproportionately large amount of your portfolio in Canadian companies. Canada makes up about 2.5 to 3% of the global stock market, and our markets are heavily concentrated in financials (e.g., banks, insurance companies) and natural resources (e.g., energy, mining), with relatively little in the way of companies that operate in the healthcare sector, for example. Investing beyond Canada is almost a necessity if your portfolio is going to be adequately diversified.
The Challenge of “Beating the Market”
Beating the market, that is, achieving an investment return greater than the return of various of the stock market indices, is a goal often sought after, but seldom consistently realized, especially recently.
Who is Taking the Other Side?
When you go into investing in individual stocks for yourself, who are you competing against? In recent years, institutional investors have become a substantial majority of market players. Examples of institutions are mutual funds, pension plans, and foundations. Getting hired in this part of the industry is increasingly difficult and only those with excellent credentials are finding their way toward employment.
The Impact of Professional Investors
These highly trained professionals, many of whom hold the Chartered Financial Analyst (CFA) designation, have access to sophisticated software and are looking for every edge, every opportunity, to gain a little bit more of a return on their investments. Consequently, the markets are becoming ever more efficient. The opportunity to invest in a stock that is overlooked by the pros but has the potential to really do well if you get in at the right time is increasingly rare.
The Alternative to Individual Stocks
Investing via Index Mutual Funds or ETFs
What’s the alternative? One of the simplest approaches is to invest in a portfolio of index funds. Typically, their management expenses are very low, as the investment process relies more on computers than stock picking. Instead of trying to beat the market, you are seeking to have your investments “be” the market, that is, get the return of the market less the small fees you pay the fund company for their management expenses. If you buy three or four funds, you can have investments that cover the world for a very small cost.
Low-Cost Actively Managed Mutual Funds
Although there is not a lot of evidence that suggests that active fund managers can beat the market consistently, one of the most important criteria in finding a winning investment is low costs. Active investment management isn’t cheap so a fund manager who can keep costs down has a greater chance of doing better, perhaps even beating the market. Depending on the investment style of the fund manager, though, you may be taking on more risk. Index funds provide their benefit by investing broadly at low cost. Actively managed funds provide their benefit by carefully researching and selecting a smaller group of companies, which means that the majority of companies are excluded from the fund.
I understand the appeal of stock selection. I did it myself. However, in the balance between risk and reward, I encourage diversification to reduce the risk which can still provide you with plenty of potential for reward.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.