This was the question investing expert Larry Swedroe recently challenged investors in this article here. I agree with most of what Larry says, hard to argue with the evidence and his expertise, but there is one thing I’m still not convinced on. Let’s review what Larry said and I’ll share my thoughts.
Individual stock ownership provides both the hope of great returns (for example, if you were to early on discover the next Google) as well as the potential for disastrous results (you could end up with a significant holding in the next Lehman Brothers).
I agree. Individual stocks bring “hope of great returns” but there are no guarantees.
Here’s another great example that demonstrates the riskiness of individual stocks. While the 1990s witnessed one of the greatest bull markets of all time, 22 percent of the 2,397 U.S. stocks in existence throughout the decade had negative returns—not negative real returns, but negative absolute returns.
Another example about the risky play individual stocks bring.
Professor Richard Thaler of the University of Chicago and Robert Shiller, an economics professor at Yale, note that “individual investors and money managers persist in their belief that they are endowed with more and better information than others, and that they can profit by picking stocks.”
I have full confidence there are tens of millions of investors who are much smarter than I am.
Investors have the false perception that by limiting the number of stocks they hold, they can manage their risks better.
I agree. This is why I invest in indexed ETFs where I can own thousands of stocks to complement my individual stock holdings.
Investors make mistakes when they take idiosyncratic, diversifiable and uncompensated risks. They do so because they are overconfident in their skills; they overestimate the worth of their information; they confuse the familiar with the safe; they have the illusion of being in control; they don’t understand how many individual stocks are needed to effectively reduce diversifiable risks; and they don’t comprehend the difference between compensated and uncompensated risks (basically that some risks are uncompensated because they are diversifiable).
You may have me here Larry. I consider my basket of 30+ stocks fairly ‘safe’ to earn passive income but potentially I should not. I guess I need to look no further than Canadian Oil Sands’ (COS) dividend cut, close to 86% cut from the dividend over the last quarter as evidence. This stock has taken a beating over the last six months. I have many other stocks that have been stellar performers (dividends and capital appreciation) but the COS experience has reminded me dividends are never guaranteed, capital appreciation for some individual stocks can fade quickly, and my crystal ball when selecting individual stocks is always cloudy.
Let me know your thoughts on Larry’s article.