Archives for August 2024

In finance, the risk from owning stocks is divided into two categories:

1. Diversifiable risk is the risk of a specific stock earning poor returns.
2. Undiversifiable risk (also known as systematic risk) is the risk that the stock market as a whole earns poor returns.

The reason for the name “diversifiable risk” is that, if you own enough companies, then diversifiable risk is mostly eliminated. You’re no longer exposed to any significant risk resulting from the failure of one particular company.

In short, “diversifiable risk” = “risk that can be eliminated via diversification.”

On the other hand, no matter how many companies you own (except for “zero,” that is), you’re exposed to the possibility that the entire stock market will have poor returns over any given period. Undiversifiable risk cannot be eliminated via diversification, hence the name.

Why the Distinction Matters

If you’ve done much reading about investing, you know that greater risk leads to greater expected return.

The reasoning is that, when an investment’s returns are volatile, it becomes less desirable to investors relative to investments with more predictable returns.  This lower demand results in a lower market price for the investment, thereby resulting in a greater expected return.

Here’s the catch that many investors miss: it is only nondiversifiable risk that is rewarded with greater expected returns.

Why? Because if risk can be eliminated through something as simple as diversification, it’s not all that undesirable. As a result, it neither decreases demand nor increases expected return.

Or said yet another way, the average dollar invested in stocks by definition will earn the average return of the overall stock market (before costs). If one stock earns better-than-market returns it’s only because another stock earns worse-than-market returns. Individual stocks, collectively, have the same return as the overall stock market. But individual stocks have much more risk than the overall stock market.

The only time it would make sense to buy an individual stock is if you understand that, yes, individual stocks in general have a worse risk/reward profile than a “total stock market” fund, but you have reason to think that this particular stock will have above average returns.

But Picking Stocks is Hard(er Than You’d Think)

For two reasons, successfully picking those winning stocks is harder than most people think.

First reason: at any given time, the price of a stock already reflects the market’s consensus expectations about the company’s future earnings.

For example, if the market expects a particular tech company to have rapid earnings growth going forward, then that company’s shares will be expensive relative to companies with lower expected future earnings (i.e., it will have a higher price-to-earnings ratio). One would say that the market’s expectations about this company’s earnings growth are “priced in” — that is, they’re already built into the price.

This means that buying shares of this stock will only provide you with above-average returns if the company’s earnings grow faster than expected. If the company’s earnings grow quickly, but no more quickly than the market expected them to, the stock’s performance will not be any better than the performance of the rest of the market (and will probably be worse).

In other words, it’s not good enough to be able to identify “this company will be very profitable in the next several years” or “this company will have dramatically growing profits in the next several years.” A stock’s performance is not determined by whether the underlying company performs well or poorly. Rather, it is determined by whether the underlying company does better or worse than the market expected it to do. There is, therefore, little to be gained from picking individual stocks unless you know something that the rest of the market doesn’t — something that isn’t already “priced in.”

And “the market” does not primarily consist of people like your coworker Jimmy of dubious financial savvy. The vast majority of dollars moving around in the market are being moved by very intelligent people, who do this as their full-time job, and who generally have better and faster access to relevant information than you do. You must know something that those people do not.

Second reason: most stocks don’t have good returns. The best-performing 4% percent of stocks explain the entire equity risk premium since 1926, as other stocks collectively earned no more than Treasury bills. And more than half of stocks delivered negative lifetime returns. In other words, you could pick 5 stocks, 10 stocks, 15 stocks, and still completely miss owning any of the future superstar stocks. You might find, after a few decades, that your individual stocks were in the vast majority of stocks that earned very mediocre returns over time.

As far as I’m concerned, if I’m going to own stocks:

1. I don’t want any diversifiable (uncompensated) risk in my portfolio,
2. I want to be sure that I’ll own whichever stocks happen to be the future superstars, and
3. I don’t want to put myself in a position where I have to outsmart the market.

So I just use boring “total stock market” index funds/ETFs.