Individual Stock Investing Increases Risk

Recent studies show that the returns to equity investors have historically come from a relatively small number of stocks. Investors who fail to adequately diversify increase their chances of failing to own those high-performing stocks, and they are not compensated for the risks they do bear.

To appreciate the riskiness of equity investing, consider that, while from 1926 through 2018 the S&P 500 Index returned 10.0% per year, it did so while experiencing volatility of almost 20% per year. In addition, it experienced four severe crashes:

  • September 1929-June 1932 (loss of 83.2%).
  • January 1973-September 1974 (loss of 42.6%).
  • March 2000-September 2002 (loss of 38.3%).
  • June 2007-February 2009 (loss of 50.0%).

Since most investors are risk averse, the potential for such great losses explains why the equity risk premium (market beta) has been in excess of an annual average of 8% a year since 1926 – investors require a large risk premium to accept the risks of large losses. What most investors fail to understand is that, as risky as equities are, investing in individual stocks is far riskier. Yet, the incremental risk doesn’t come with any incremental compensation. The reason is that the market doesn’t compensate investors for risk that can be diversified away.

Most investors are unaware that while there has been a positive risk premium (in excess of riskless one-month Treasury bills) for the overall stock market, there has actually been a negative risk premium for most individual stock returns. That result is explained by the strong positive skewness in returns to individual stocks, particularly at longer horizons – the mean (the value-weighted average) return is well above the median return. Put simply, the positive mean excess return for the broad stock market is driven by very large returns to a relatively few stocks, not by positive excess returns to most stocks.

Most investors will not only be surprised at the evidence, but shocked.