Episode 363 - The (Underappreciated) Risk of Individual Stocks

23:59It also extends to the lifetime of stocks rather than the 1980 to 2020 sample period that JP Morgan used. The data in Besseminder's study are a little bit better at the 10-year horizon compared to the lifetime horizon. At the 10-year horizon, 49.5 % of stocks beat treasury bills, 37 % beat the market. But still, brutal numbers if you're picking stocks hoping to beat the market. Then there's also the global skewness data. Bessenbender has his US paper. He's also got a global stocks paper. The skewness in global stocks is even worse than it is in US stocks. You're not making a compelling case to stock pick.

24:35Well, I don't think there is one, really. It's kind of the idea. This is a cool paper. There's a 2023 paper, Underperformance of Concentrated Stock Positions. They use a set of all US stocks, but they exclude the smallest stocks from 1926 to 2022. The way that they describe their data is that in more recent history, it looks like the Russell 3000, but they also go back further in time when there were fewer stocks in their index, but they have a size cut off. They take a slightly different perspective, but they're again looking at concentrated positions. So the author finds that the median 10-year US single stock return in their sample is a cumulative negative 7.9 percentage points relative to the market.

25:16That's about 0.82 percentage points in annualized terms. And also that 55 % of individual stocks trail the market at the decade horizon. They also show how the volatility of a portfolio changes with an increasing weight in a concentrated position by modeling various portfolios consisting of the market index and an increasing allocation to an individual stock. And what they find, this is where that 10 % being the definition of a concentrated portfolio comes from. They find that portfolio volatility is relatively unaffected by single stock positions at weights up to 10%, but then increasingly affected thereafter.

25:53And the effects are more pronounced for individual stocks with higher idiosyncratic volatility, which makes sense. If you hear all this pessimistic data and think that, well, nobody would buy a loser stock. I only buy winning stocks, or I only hold my stocks have been performing well. This is the fascinating data point from this paper. Stocks with top 20 % performance over the past five years have a median cumulative return over the following 10 years of negative 17.8 percentage points relative to the market. That's an annualized 1.94 percentage points. 60 % of these stocks, as opposed to 55 % of all stocks, trail the market at the decade horizon.

26:31And recent winners, like the stocks that, like I said earlier, I would argue are the ones that are more likely to make up a larger portion of investor portfolios. Those ones perform worse, not better at the 10-year horizon. Pretty interesting. That applies across all industry groups and also among both the smallest and largest stocks. Like you said, Cameron, I'm not making a great case for investing individual stocks. I think the important takeaways from these studies are that positive skewness in individual stock returns means that you're much more likely to pick a loser than a winner when you're selecting an individual stock.

27:03And the effects of skewness are more extreme at longer horizons. So that means that the chances of being a successful long-term buy and hold investor with only a few stocks is increasingly unlikely at longer horizons. However, like we said, Bessemender cuts both ways. If you do pick the rare winners, the results can be extremely positive. And the other thing is underperformance can happen quickly, unexpectedly, and irreversibly. A lot of stocks not only underperform the market, but they suffer catastrophic losses that they do not recover from, unlike a diversified portfolio, which tends to bounce back.

27:38It is worth emphasizing that it is true that a small number of stocks perform exceptionally well. It's just really hard to pick them before the fact. And past winners are more likely to underperform than outperform in the future. Some level of diversification probably makes sense, as we know. That's another interesting question, though, is how much diversification makes sense. Individual stocks are risky, fine. So we should diversify, fine. How many stocks should you own? What is a diversified portfolio? There are a couple of papers, very highly cited papers from the 1970s and 80s that find kind of a 20 to 30 stock portfolio is sufficient for diversification.

28:17And the way that they approached is that beyond that point, the risk reduction benefits diminish. Now that 20 to 30 stock finding has colored the beliefs of many investors. The problem with it is that it assumes that volatility is the only measure of risk that matters to investors. They show that the volatility reduction benefits of additional stocks levels off after 20 or 30. I would argue that what matters to investors is the expected distribution of long-term wealth outcomes, not the short-term volatility. If you think about a more concentrated portfolio has a small chance of holding the mega winner and a much larger chance of holding the losers, even if they have similar volatilities, I don't know if they would, but say they have similar volatilities, the difference in wealth accumulation between the worst and best concentrated portfolios is going to be huge.

29:04It's going to be enormous at long horizons. Reducing volatility is for sure a good thing. That's one of the things that diversification can help with. The other interesting thing is that at very long horizons, even small differences in volatilities can have big impacts on long-term wealth accumulation. Really interesting. We talked about this in some of our earlier way back episodes about concentration versus diversification in factor investing. We talked to Wes Gray about that. Wes Gray, exactly. It is a very interesting topic. There is a 2022 study by Roni Israelov, how many stocks should you own?

29:39They simulate long-term wealth outcomes for portfolios with varying levels of concentration. They find that the 25th and 10th percentile outcomes, so basically the worst outcomes in their simulations, improve quite dramatically until around 250 stocks are included. Then the incremental benefits of diversification really decrease after that. The average portfolio in their simulations multiplied wealth 19 times over 25 years on average, but an investor with just 25 stocks had a one in 10 chance of receiving less than a 12 times multiple. An investor with 250 stocks had a one in 10 chance of achieving less than a 17 times multiple of wealth.

30:20See that distribution is a lot wider. The left tail is a lot worse with a more concentrated portfolio. The worst outcome is less bad. The best outcome is also less good, which is interesting because that's not necessarily a good or bad thing. It does make the choice about how diversified a portfolio should be a preference more than a prescription. You can't just say, well, you should have this many stocks. but I think it's worth highlighting that when risk is measured as the variability of terminal wealth, the diversification benefits of adding more stocks does continue far beyond that 20 to 30 holdings that sometimes get cited.

30:53If you're confident you can pick winning stocks before the fact, portfolio concentration can make sense, but the odds are stacked against you. The track record of active management in general does leave much to be desired as we know and as we mentioned with Bessenbender's research. It is worth saying that some investors may be comfortable with that risk. They may be willing to accept a wider range of long-term outcomes, including a good chance of trailing the market or even suffering a catastrophic loss in exchange for a smaller chance at extreme outperformance. It's like a preference for a lottery-like payoff, which you can't say is right or wrong, but I think it is just a risk that needs to be properly understood for anybody holding a concentrated portfolio or for holding a single stock.

31:35Bessenbender's do stocks outperform on treasury bills, he simulates long-term returns for 20 ,000 portfolios of randomly selected 5, 25, and 50, and 100 stock portfolios. He finds at the 10-year horizon that even 100 stock portfolios outperformed the market only 47.5 % of the time. That was a crazy finding from his paper too. Now, there are a few different ways to interpret that result. One way is that, well, hey, it was only a little worse than a coin flip that you would have beaten the market before costs. The other is that you had more than a 50 % chance of trailing the market. Now, the nice thing about total market index funds, and even I think I would group dimensional funds into that category because they still own that broad cross-section of all the stocks in the market.

32:18The nice thing with that approach is that you know you're going to get the market return in the case of dimensional plus or minus some factor premiums, but you know you're going to get the market return even if you don't know what the market's going to be. With a really concentrated portfolio, you might still get the market return, but it's going to be plus or minus the active return from portfolio concentration. And that range of outcomes for the active return is going to be a lot larger with increasing portfolio concentration. And the distribution of outcomes of all the concentrated portfolios is going to have lots of losing portfolios and a few big winners.

32:51And that skewness will decrease as you increase the diversification of the portfolio. There is research from Vanguard showing that active share, which is not the same thing as concentration, but it is related. We actually have an episode with Martin Kramers, who created that measure coming up. Vanguard has research showing that higher active share results in a wider dispersion of benchmark relative returns for actively managed funds. It becomes a question of how confident you are that the stocks you pick will be winners rather than losers, while keeping in mind that the distribution of individual stock returns is pretty intimidating.

33:26Another interesting point here is that portfolio concentration can have asymmetric effects on performance. There's a 2022 paper, Fund Concentration, a Magnifier of Manager Skill. The author finds that increasing concentration has a pronounced positive impact on performance for outperforming funds, which makes sense. If you take more concentrated funds that have done well, they will have done well more so than more diversified funds. But the opposite is true for underperforming funds. And this is a really interesting point though, higher levels of concentration generally hurt the poorly performing funds more than it helps the outperforming funds.

34:02This is another interesting point on the concentrated positions thing. We talked about a few different paths that you could have taken to end up with a concentrated position, but most of those paths lead to both or some combination of economic and psychological barriers to diversifying. I think the biggest economic barrier, we talked about this earlier with the Nortel example, is taxes. You own a stock that increased in value substantially, leading to it being a concentrated position, there's probably a large tax bill associated with selling it. An important thing about it in that case is that the taxes generally don't go away, at least not in Canada.

34:35In the US, there can be some estate planning, but in Canada, the tax bill doesn't go away. The only thing you can do is control whether you realize the gain now or later, because it's coming no matter what. Deferring taxes can be a good thing, but in this case of a concentrated stock position, it is being traded off against taking a large amount of idiosyncratic risk. There are some strategies in Canada like tax efficiently donating the appreciated securities that can make sense. If you're going to make a donation anyway, then this can make sense. Donating them for the sake of donating them when you wouldn't have otherwise, that's not really helping you with your tax bill.

35:10It sort of is, but you're also giving away the assets. But if you're going to make a donation anyway, this can be a very tax efficient way to do it. But that said, it's a relatively complex planning and it's got to be approached very carefully and in the context of the overall financial plan. Another less common economic constraint that can still be relevant is control. Some large shareholders of a company that have a concentrated position may need to maintain their large position in order to maintain voting control of the company. That's obviously a much harder one to overcome. The psychological constraints to diversifying include the representativeness bias where people ignore the types of base rate probabilities that we've discussed in this episode and assume that their past performance with a single stock is indicative of its expected range of outcomes.

35:53There's also the endowment effect where people prefer things that they already own. There's the status quo bias to stick with the thing that you're already doing. I own this stock, so I'm just going to keep holding it. It's easier to not make a decision than it is to make one. And in the case of a stock that's fallen in price, we also have the disposition effect. So managing those biases with respect to diversifying a single stock position can be challenging. A couple of things that can help. One is imagining that the amount you have invested in the single stock is in cash and asking yourself if you would buy the stock today.

36:25And then another one, and this is one that I got from someone who I told the first one to, and I kind of took it away and thought about it. And they came back and said, I tried doing that. I tried imagining that it was cash and I wouldn't have bought it, but it didn't help me sell. I was still stuck. And so they came up with something that did work for them, which was creating a systematic plan to dollar cost out of the concentrated position. So it avoids the psychological impact of making one big decision and having it not work out. Makes sense. I'm still in the cash camp. I find that one pretty effective.

36:55I like that model too, but it doesn't work for everyone. And if it doesn't work for someone and dollar cost averaging out, if someone says, I just can't do it, I can't sell the whole position. I like putting something systematic in place. It's tough being a human. Well, it's tough investing as a human. Humans are not designed to be long-term investors in these abstract financial instruments that we call stocks. So stocks are extremely risky, as I hope we have articulated. Most of them by number underperform the market. Many of them have negative long-term returns or more extreme catastrophic losses, and a smaller portion of them have extremely high returns.

37:32Picking any one stock is more likely to lead to a bad outcome than a good one. And counterintuitively from one of those papers, that is even more pronounced for stocks that have performed well over the last five years. So the simple answer is to overcoming individual stock risk is of course diversification. The extent of diversification that makes sense depends on your preferences for skewness. Some people might want skewness. Also your conviction in your stock selection ability and your willingness to bear the risk of a wider range of potential outcomes. And then getting out of a single stock position.

38:04It can have economic and psychological challenges, but those can be overcome with thoughtful planning. And that's something that we've seen many clients do. All right. You've convinced me. Mission accomplished. That's good. I'm a changed person because of this. Glad you're convinced you're going to go sell all of your Tesla and NVIDIA shares. That's right. I'll get on that right now. So I have to ask you, where did this idea come from for this? I'm just curious in the process. I'm guessing a lot of listeners have a similar question. Where did the idea for the specific topic come from? I don't know.

38:38Did this come out or does it come from a client or from a comment or just came to you? I can't remember. Some people think there's some sort of master communications plan behind all this. And we've said many times, no, this is a pretty messy omelet making station. I'd love it if someone came to me and said, Dan, you should make a video about this, then I could do it. So here's my next question. So you come up with a topic. what's your process to then go and discover it? Because you referenced many papers and studies here. What's your next piece of the process? For this one, I think it might've just been that there were a few papers that I had read on this, like the Bessem Bender papers that everybody's read.

39:15Everybody. I mean, maybe not everybody. I've read them. But they're familiar with a lot of people. It's fair to say that. Yeah. And then there are the JP Morgan studies that I've read those before Bessem Bender had written his 2018 paper. I'm aware of those. They're connected and they're slightly different data, slightly different ways of presenting the analysis. Then there's the more recent one, there's the 2023 paper, the underperformance of concentrated stock positions. How do you find them? Do you go to SSRN and search or you chat GPT? How does that process happen? I have no idea. Sometimes it'll be something as simple as I'll be looking somebody up as a potential rational mind or guest.

39:52And when I do that, if I've seen a few papers from somebody and I'm like, this person could be interesting. So I'll go and look them up on SSRN or on their university website if they're at a university. And I'll go and just flip through their papers, their working papers and their published research. And in many cases doing that, they don't rank well on Google academic papers. And so I'll find a paper that I hadn't seen before. I think that's how I found the underperformance of concentrated stock positions. and then I go and read it and it's like, oh, it's another interesting perspective on that topic, on individual stock risk.

40:22For this video, there were enough unique perspectives. The Bessenbender paper, there's the JP Morgan studies. There's the Antipedisto paper that I hope I pronounced the name correctly. That's the underperformance of concentrated stock positions paper. And then the Roni Israelov paper on how many stocks you should own. That's probably enough content to talk about for a video. So then I just write it up into a video. So you read them, you think about it, you get your outline, catalog the studies. I assume you get them saved in a database or something, you cross-reference. There's no database. It's just interesting how it all comes together.

40:56They're linked in my Google document. I do have all of my past video scripts and Rational Reminder episodes in a Google Drive folder. I will go back and reference them. What was that study that we talked about? And I'll go back. It's not quite a database and it's not very well-structured, but it is there. Are you using AI much to help you to do all this? Off and on, I still find it pretty useless. Some people will probably be so offended to hear that, or they'll think that I'm an idiot for not being able to use it properly, but it makes serious, serious mistakes. It's a little bit useful for finding obscure studies.

41:31It's also useful for finding studies when you don't have keywords, but you have a more abstract idea of a topic that you want to read about or whatever. It's kind of useful for that, but honestly, like using Google Scholar is also pretty good. I do use it quite a bit, but I don't trust it. So this helped you craft a YouTube video script and then you repurpose it effectively here, correct? Most of our podcast episodes like this, where we're like delivering a topic or a video essay or whatever, usually I write that, even if I don't end up making a video on my channel on the topic. I'll write it as if I were going to.

42:10I just find it works well to think about it that way because I have like a target length that works well, both for the podcast and for the YouTube channel and structuring the narrative. I find thinking about it as if I were going to speak it works well. But yeah, typically I'll write it as a video and then we do it as a podcast episode. And do you ever have writer's block or do you ever find yourself, man, I don't have a topic. Like I got to scramble. Hasn't happened yet. It's been eight years or whatever. I don't know. Maybe one day. That would be pretty terrifying. Because it's not like we're recycling all the same topics over and over again.

42:44A lot of the common themes, yes, but it's not like a greatest hits. It just keeps going on repeat. I did a video years ago on individual stocks and I went back and read that script after I'd written most of this one just to see if I had any other ideas in there that I hadn't already covered in this video. And it was actually strikingly similar to that past one. So maybe I am recycling ideas now. Have we talked about your appearance on the Morningstar podcast here? I don't think we have. You and I haven't. I did mention it in one of the episodes with Dan, but that was a while ago. So yeah, I was on Morningstar's The Long View podcast with Christine Benz and Amy Arnott.

43:23It was a good conversation. You should check it out. I found you super chill. almost like you had some sort of, I don't know, relaxant or something. You're so chill and easygoing. You're like, ah, sure. I found some of your answers so refreshingly normal. You had not told me that. It was a good conversation. It was really smooth. I called you the velvet fox or something. You're just so smooth and you seem chilled on the conversation. They were great, but your answers are very straightforward and they're well done, of course. Your answers are great. It was a good conversation. They do a good job.

43:53I've been aware of their podcast forever, but I've binged listens to a few of them. We've got some good episodes. Separate topic, Ben. We've talked about bringing not so much the show, but us hitting the road, doing meetups in various centers. So I put it out there to listeners. If there's advisors out there that might want to meet up in a different city, we're just thinking of getting back to, remember we did some meetups in Montreal and Toronto and Ottawa, which we would do those of course, but perhaps go broader. So if there are people in different cities across the country that might like to help us coordinate something, let us know.

44:24We can do an RR type meetup, or we could also do an advisor meetup. Let's be clear about it. Totally happy to do meetups and meet people that are listeners and stuff like that, but we would love to meet advisors that are potentially interested in joining our firm. That's one of our big objectives. And one of the reasons that we did our deal with OneDigital is to give us the capital to acquire like-minded advisors across Canada that can contribute to what we're building at PWL. So if those people are out there and want to meet up, let us know. And my last question, which might be the most important one, are the premium t-shirts back in stock?

44:58I don't know. I have not asked Angelica or Jackie, but let's check it out in the store here. Sold out. Sold out still. I just know we got a shipment in the office. I didn't know if there's any shirts in there. All sizes are sold out. That's wild. I knew they were going to be hot. I knew it. You were right. I predicted the market on this one. We got pictures of people in them and I know Will, a friend of my, a good friend of my daughter's, loves it. He's also a big fan, so shout out to Will, but loves this shirt. They're cool shirts. They look great, well-made. The contrast with the white and the black, it's such a good nerdy inside joke.

45:32I was talking with a doctor at a medical appointment, not cancer-related, just to check up. Although we did talk about that, obviously. He was like, what do those letters in your shirt mean? Because I was wearing the premium t-shirt. And I was like, it's an asset pricing model. It's a finance thing. I don't know. and he's like, well, no, can you try and explain it to me? So I went through each premium of what it means and he's like, huh, it's really interesting. Look at you, always selling. I have nothing to sell, just talking about asset pricing models. It's a real conversation starter. Which is what everyone should do with their doctor.

46:08Yeah, I guess so. Okay, anything else going on? I know your renovations are progressing well in your front yard, so that's exciting. I'll have to come check it out. progressing is, I don't know if I'd quite use that word. They have progressed. So funny. Okay. Anything else? I don't think so. I don't know if I answered the question about the premium t-shirts, but they are coming back. We have ordered more. They will be restocked. As of the time we're recording this, they have not been restocked, but maybe by the time the episode's released, I don't know. All right. Cool. Well, beautiful June day in Ottawa.

46:40Love the summers. It's a bit humid. I grew up on Vancouver Island, BC, where the summers are also nice, but we don't have the humidity out there. So my travels this past month, I went from Vegas, which is super hot and bone dry. It was 41 degrees one day. Then I went to conference in South Carolina where it's super hot and like 100 % humidity. And now I think we must be close to that here in the auto area. It's humid. I remember the first time I was in Texas and the first time that I was in Vegas, it was just such a different feeling when you walk into the hot air. It's like, whoa. Oh, it just cooks you, but there's no humidity.

47:13You don't sweat from walking around. but man, it's hot. Give them that there. They know how to do hot. All right. Great topic. Great chat. Good to see you. As always. Good to see you. And everybody, thanks for listening. Thanks for listening.

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49:10Thank you.