Picking stocks may not be as easy as you think
As originally appeared in The Jerusalem Post on December 23, 2021.
“Finance is not merely about making money. It’s about achieving our deep goals and protecting the fruits of our labor. It’s about stewardship and, therefore, about achieving the good society.” – Robert J. Shiller
It’s been a roller-coaster ride, but all in all 2021 has been a good year in financial markets. The markets have withstood multiple COVID variants, lockdowns, surging inflation, and the anticipation of higher interest rates.
As I have mentioned in previous columns, while the major market indices are not far off from their all-time highs, many popular and widely held stocks have tumbled 20% or more. In fact, almost 30% of all the gains in the S&P 500 this year come from just five companies. That means the other 495 have not really pulled their weight. Remember Zoom? It has taken over the world and virtually eliminated the need for face-to-face meetings. Yet their stock is down nearly 60% in the last 10 months.
There is evidence that owning individual stocks may not be the best way to secure your financial future. JP Morgan came out with a report titled “The agony and the ecstasy: The risks and rewards of a concentrated stock position.” It’s a report based on 40 years of data. They took data starting in 1980, and show that owning an individual stock, statistically, probably wasn’t such a good idea.
In the report, Michael Cembalest writes, “How often would a family have been better or worse off owning cash, or the Russell 3000 Index instead of the concentrated position? Around 40% of the time a concentrated position in a single stock experienced negative absolute returns, in which case it would have underperformed a simple position in cash. Around two-thirds of the time, a concentrated position in a single stock would have underperformed a diversified position in the Russell 3000 Index. While the most successful companies generated massive wealth over the long run, only around 10% of all stocks since 1980 met the definition of “megawinners.” If you were lucky enough to own one or more of that ‘megawinning’ 10%, then those positions had huge returns.
He also writes, “More than 40% of all companies that were ever in the Russell 3000 Index experienced a ‘catastrophic stock price loss,’ which we define as a 70% decline in price from peak levels which is not recovered.”
What do we learn from this? If you think you will become a millionaire from owning one stock, chances are very slim you will succeed. We also learn how important it is to diversify and own many stocks in order to have a few megawinners, to help bring up returns and make up for underperformers that you will inevitably own.
The problem with owning many stocks is that for most investors, they don’t have the time to really analyze and follow 30-40 different companies. For them, it’s probably most efficient to either use a money manager who invests in a portfolio of individual stocks, or use products like ETFs (exchange-traded funds) which track specific stock market indices and own in some cases hundreds of stocks.
It’s certainly fun owning and talking about stocks, but as I have said 1,000 times, creating your asset allocation, or the mix of stocks, bonds, and cash in your portfolio, is the single most important task for an investor. Many studies have shown that the proportion of stocks, bonds, and cash held in a portfolio has a greater effect on its returns and volatility than the individual investments that are chosen.
That is why after assessing one’s investment goals, it’s of the utmost importance to create an allocation that can help you achieve the aforementioned goals. Especially after the market run-up of the last few years, it’s important to re-assess your portfolio.
In time periods with solid stock returns, many investors can find themselves with portfolios much more heavily weighted toward stocks than they bargained for. One of the most overlooked aspects of long-term investing is the need to rebalance a portfolio. Rebalancing is important for two main reasons. First of all, it keeps your portfolio in tune with your long-term goals, and second, it keeps your asset allocation in line with your risk level.
What’s the upshot of all of this? There is nothing wrong with owning individual stocks as long as you own enough of them, and that you are well diversified across most sectors of the economy. If you don’t feel that you have the ability to manage it yourself, due to both time and knowledge restraints, then outsource the management of your money and use solid, chocolate/vanilla solutions like ETFs. If you follow your asset allocation and rebalance your portfolio, you will be able to achieve your financial goals.
The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc. or its affiliates.
Aaron Katsman is the author of Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing (McGraw-Hill), and is a licensed financial professional both in the United States and Israel, and helps people who open investment accounts in the United States. Securities are offered through Portfolio Resources Group, Inc. (www.prginc.net). Member FINRA, SIPC, MSRB, SIFMA, FSI. For more information, call (02) 624-0995 visit www.aaronkatsman.com or email aaron@lighthousecapital.co.il.
