Episode 363 - The (Underappreciated) Risk of Individual Stocks

Episode Summary

Executive Summary: The episode argues that individual stocks are far riskier than most investors realize, with returns heavily skewed toward losers and a few huge winners. Using research from Bessembinder, JPMorgan, and others, the hosts explain why concentration raises the odds of underperformance, catastrophic loss, and irrecoverable decline, and why broad diversification remains the simplest defense.

Main Topics: Why individual stocks are unusually risky (Priority: 5/5): The hosts explain idiosyncratic risk, positive skewness, and why most single stocks are poor long-term holdings relative to diversified portfolios. How concentrated portfolios arise (Priority: 4/5): They discuss common paths to concentration: overconfidence, employer stock compensation, IPO lockups, and inherited or appreciated positions like Nortel. Empirical evidence on stock return distributions (Priority: 5/5): They summarize multiple studies showing that most stocks underperform, many suffer catastrophic losses, and a small minority drive market wealth creation. How many stocks are needed for diversification (Priority: 5/5): The episode revisits the old 20-30 stock rule and contrasts it with newer research suggesting benefits continue well beyond that, especially for terminal wealth outcomes. Psychological and tax barriers to selling concentrated positions (Priority: 4/5): They review biases like endowment, status quo, representativeness, and disposition effects, plus tax friction and control considerations that make de-risking hard. How to think about acting on the evidence (Priority: 3/5): The hosts suggest practical approaches such as imagining the position as cash or using a systematic plan to dollar-cost out of a concentrated stock position.

Key Arguments: Individual stocks carry uncompensated idiosyncratic risk; diversification removes this without reducing expected return. The distribution of single-stock returns is positively skewed: many losers, few massive winners, making stock-picking a low-probability strategy. Recent winners are often the worst long-term candidates; top-performing stocks over the prior five years tended to underperform over the next decade. Catastrophic losses are common and often permanent, so holding on for recovery can be a dangerous illusion. The old claim that 20-30 stocks are enough relies too much on volatility; long-term wealth outcomes can remain meaningfully improved by far broader diversification. Concentrated portfolios can amplify both skill and skill deficits, but the downside tends to hurt underperformers more than concentration helps outperformers. Taxes, control rights, and behavioral biases often prevent investors from diversifying even when they understand the risk. Broad market index funds, including diversified factor-based funds, provide the market return with far less uncompensated company-specific risk.

Data Points: Russell 3000 catastrophic losses: 44% - Share of companies in the Russell 3000 from 1980-2020 that experienced a 70% decline from peak to trough and never recovered. Stocks with negative absolute returns: 42% - JPMorgan report on Russell 3000 constituents from 1980-2020. Stocks that trailed the market: 66% - JPMorgan report: share of Russell 3000 stocks that underperformed the index over 1980-2020. Mega winners: 10% - Russell 3000 stocks from 1980-2020 that beat the market by 500% or more. Lifetime returns above T-bills: 42.6% - Bessembinder study of U.S. common stocks from 1927-2016. Lifetime returns above the market: 30.8% - Bessembinder study of U.S. common stocks from 1927-2016. Negative lifetime returns: More than 50% - Bessembinder study: majority of common stocks had negative lifetime returns. 10-year beat T-bills: 49.5% - Bessembinder study at the 10-year horizon. 10-year beat the market: 37% - Bessembinder study at the 10-year horizon. Pre-fee active mutual funds beating SPY: 45.2% - Referenced Bessembinder result on pre-fee mutual fund returns versus net-fee SPY/ S&P 500 ETF returns. Median 10-year single-stock return vs market: -7.9 percentage points - 2023 study on underperformance of concentrated stock positions. Annualized median 10-year underperformance: -0.82 percentage points - Same 2023 study, translated to annualized terms. Stocks trailing market at 10 years: 55% - 2023 concentrated stock positions paper. Top 20% past 5-year performers: future underperformance: -17.8 percentage points - Median cumulative 10-year return relative to market for prior five-year winners. Top 20% past 5-year performers trailing market: 60% - 2023 concentrated stock positions paper. Portfolio volatility threshold: About 10% single-stock weight - 2023 paper suggests volatility is relatively unaffected by single-stock positions up to roughly this weight. Diversified portfolio simulation horizon: 25 years - Roni Israelov study simulating long-term wealth outcomes for portfolios with varying stock counts. Average wealth multiple: 19x - Israelov simulation average over 25 years. 1-in-10 outcome with 25 stocks: Less than 12x wealth multiple - Israelov study: 10th percentile outcome for 25-stock portfolios. 1-in-10 outcome with 250 stocks: Less than 17x wealth multiple - Israelov study: 10th percentile outcome for 250-stock portfolios. 100-stock portfolios beating the market: 47.5% - Bessembinder simulation result mentioned in episode.

Pivotal Quotes: "Diversification is the only free lunch in investing." — Benjamin Felix: Used while explaining why diversification reduces risk without reducing expected return. "The chances of an individual stock that's performed well in recent history underperforming in the future, the chances are greater and the magnitude is also greater." — Benjamin Felix: Summarizing evidence that recent winners are often poor long-term holdings. "Picking any one stock is more likely to lead to a bad outcome than a good one." — Benjamin Felix: Core takeaway on the distribution of single-stock outcomes.

Implications: Listeners should treat single-stock exposure as a deliberate gamble, not a neutral default. Broad diversification is still the most reliable way to avoid catastrophic loss, while concentrated positions require clear-eyed risk tolerance, tax planning, and behavioral discipline.