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Picking Stocks | Common Sense Investing - YouTube
Channel: Ben Felix
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- Today I want to talk to you
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about owning individual stocks.
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I know, I'm not going to tell
you how to do it successfully.
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This is not that kind of channel.
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I have talked in past
videos about the difference
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between systematic and
non-systematic risk.
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Systematic risk is a risk that
cannot be diversified away.
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Market risk, is a systematic risk.
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As are the risks of small
cap and value stocks.
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These are the risks
that we are stuck with.
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But they're also compensated risks.
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We expect a positive outcome
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for taking on these undiversifiable risks.
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Non-systematic risk is the risk
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of an individual stock or bond.
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This type of risk can be
easily diversified away,
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using low-cost index funds.
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Since this is a type of risk
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that can be easily diversified away,
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It is not a compensated risk.
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You do not reasonably expect
a long-term positive outcome
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for betting on a single security.
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Despite this, many people still choose
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to irrationally hold large
positions in individual stocks.
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I'm Ben Felix associate
portfolio manager at PWL Capital.
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In this episode of Common Sense Investing.
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I'm going to tell you why
individual stocks are even riskier
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than you might think.
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(upbeat music)
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Before I start the episode.
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I do want to let everyone know
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that I've started a weekly podcast called,
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The Rational Reminder.
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It's a reality check on sensible investing
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and financial decision
making for Canadians.
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Hosted by my PWL Capital
colleague Cameron Passmore.
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If you enjoy my Common
Sense Investing videos,
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I think that you will
really like the podcast.
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I've put links to The Rational Reminder
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in the description below.
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Let's talk about
individual stock ownership.
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I think that on one hand,
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everyone knows that it is not sensible
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to own individual stocks,
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but on the other hand,
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everyone has a bit of
an edge to speculate.
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That itch to speculate
is driven by a handful
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of biases that are not always easy to spot
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or to overcome.
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I get it.
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I have seen people get rich quickly
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by investing in crazy assets like Bitcoin,
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tech stocks and cannabis stocks.
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That is a real thing that
has happened to some people.
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And it is one of the things
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that makes it really
hard for everyone else
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to ignore the potentially
positive outcome.
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We will come back to the
distribution of outcomes later,
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and I think you will want to stick around
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or at least skip ahead to hear about it.
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But it is important to understand
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that stock prices are random.
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When someone is successful in speculating,
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it should almost certainly
be attributed to luck.
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The problem with that though,
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is it never feels like
luck when it happens.
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There is a massive opportunity
for confirmation bias,
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which means that people
take the random outcome
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of a stock going up,
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and they attribute it
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to their prior belief that it would go up.
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Now, not everyone who speculates
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on individual stock is a savvy trader.
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I think that one of the most common cases
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for concentrated positions
in an individual stock,
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is probably people who have
received equity packages
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from their employer.
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That specific case results in a handful
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of biases that apply to all investors,
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being extra strong
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for employees who hold
stock in their employer.
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It is extremely easy to confuse
familiarity with safety.
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When you know the long-term
plans of your company,
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and the leadership treats you like family,
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it is a lot harder to
objectively assess the risks
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of owning the stock.
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This may be especially true when the price
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of a stock has gone up over time.
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In a 2001 paper titled,
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"Excessive Extrapolation
and the Allocation
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of 401k Accounts to Company Stock."
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Shlomo Benartzi found that employees
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of firms that experienced
the worst stock performance,
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over the trailing 10 years,
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allocate 10.37%
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of their discretionary
contributions to company stock,
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where employees whose firms experienced
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the best stock performance allocate 39.7%.
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I don't think that I need to remind any
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of you that past performance
is not a good indicator
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of future performance.
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Any investor that owns an
individual stock is overconfident.
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But this is probably even more true
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when you're holding a large position
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in your employer company stock.
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Not only do you believe in the company,
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but you feel like you have an impact.
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This is overconfidence bias combined
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with an illusion of control,
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that makes it really really hard
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to understand that your
thoughts, feelings,
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and hard work have nothing to do
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with your company's share price.
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Illusion of control can
affect other investors too.
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If you have put a lot of time and effort
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into researching the
potential outcomes of a trade,
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you may feel irrationally,
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that you are in control of the
probability of the outcome.
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This is almost never true.
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Whether they are an employee
of a company or not.
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Investors have a strong tendency
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to overvalue assets that they already own.
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This is called the endowment effect.
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Which was popularized by
Kahneman, Knetsch and Thaler
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in the 1991 paper,
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anomalies the endowment effect,
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loss aversion and status quo bias.
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It is well documented that
investors are less willing
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to part with an asset that they own,
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even if they would not buy that
asset at its current price.
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Say you bought a stock for
five dollars per share,
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and it increased in price to $50.
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Would you sell it or would you keep it?
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Many people would keep it,
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but would not buy more at
the current high price.
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This is not rational.
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If you would not buy more
at the current price,
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you should not keep it.
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A good way to check the endowment
effect is to ask yourself,
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if you had the value of
your shares and cash.
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Would you buy the shares?
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Framed this way.
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Most people will change their mind.
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I doubt this information is new to anyone.
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But even when we are aware
that we are being irrational,
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we tend to overweight the
likelihood of positive outcomes.
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Well, underweighting the probability
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of extremely negative outcomes.
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What's an extremely negative outcome?
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Nortel, Enron, Lehman, Bear Stearns.
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Those are just some big names
I picked to make the point
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that stocks can go to zero,
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but there are many, many others
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that you probably haven't heard of.
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It is possible,
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and not at all unheard of,
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for companies to disappear,
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taking their share price with them.
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Well, it can happen.
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I do agree that a total
loss seems unlikely.
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Much more likely is underperforming
the market over time
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or suffering a permanent loss.
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In a May, 2018 paper titled,
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"Do Stocks Outperform Treasury Bills?"
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Hendrik Bessembinder of
Arizona State University,
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demonstrated that the vast majority
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of stocks that have appeared in the center
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for research and security prices database,
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which is a comprehensive
database of US stocks.
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Since 1926, I have a lifetime buy
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and hold returns less than
one month treasury bills.
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In other words,
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you would have been
better off taking no risk
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with your capital
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than investing in most individual stocks.
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What does most mean?
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It means that the best
performing four percent
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of listed companies explain the returns
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of the entire US stock market since 1926.
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The remaining 96% of stocks,
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collectively match the
returns of Treasury Bills.
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That means that you would
have been better off
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taking no risk at all than holding 96%
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of the individual stocks
in the US since 1926.
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I'd call your chances of picking
a winning stock pretty bad.
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That is called skewness.
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The data only get worse the deeper we get.
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Only 42.6% of the nearly
26,000 common stocks
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that have appeared in the crisp
database from 1926 to 2016,
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have a lifetime buying hold return greater
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than the one month Treasury
Bill over the same period.
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The rates of under-performance are highest
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for small cap stocks
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and for stocks that have
entered the database
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in recent decades.
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Eugene Fama and Kenneth French
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had a 2004 paper addressing
the second point.
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They demonstrated that
starting in the 1980s,
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weaker firms with less profitability
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and more distant future payoffs
were listing on exchanges,
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leading to lower new
lists, survival rates.
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Based on this it would
be reasonable to expect
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that the discouraging skewness
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of the past will be even more
pronounced in the future.
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A bit of under-performance
doesn't sound so bad, right?
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If you want to speculate,
you know you are taking risk.
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Unfortunately it's not
typically just a bit
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of under-performance
that you should expect.
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A 2014 study from J.P. Morgan
looked at data going back
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to 1980 for the S and
P 500, the Russell 3000
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and a handful of specific sectors.
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Most telling is the data on
the Russell 3000 companies,
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which encompasses most of the US market.
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The study shows that of the
13,000 stocks that were included
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in the Russell 3000 index
between 1980 and 2014,
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40% of them suffered a
decline of 70% or more
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from their peak value,
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without a significant recovery.
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You heard that correctly.
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40% of companies included
in the index at some point
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between 1980 and 2014 had
suffered a 70% decline
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from their peak value,
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recovering to at best
a permanent 60% decline
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in value from their peak.
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Those catastrophic
losses are more frequent
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for certain industries
like information technology
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with a 57% catastrophic loss rate,
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telecommunications at
51% and energy at 47%.
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The study goes on to explain
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that these losses do not
only happen during recessions
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or market corrections.
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They're happening
steadily all of the time.
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It also explains that two
thirds of all excess returns
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versus the Russell 3000
index were negative.
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And 40% of all stocks had
negative absolute returns.
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This means that 67%
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of stocks underperformed
the index over the period.
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And 40% had negative returns.
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I do not think that this
data is what people have
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in mind when they buy or
hold an individual stock.
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They see the glamor of all
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of the money that they are going to make.
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And while they may on
some level understand
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that it is a risky bet.
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I doubt that most people
understand how badly
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the odds are stacked against them.
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Historically, you are far more likely
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to pick a loser than a winner.
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And that loser is highly likely
to not only trail the index
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but to have negative absolute returns.
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Today we have talked about the biases
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that make you falsely believe
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that owning individual
stocks is a good idea.
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And we've talked about how
badly the vast majority
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of individual stocks
have performed over time.
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If you still have a hankering
to maintain exposure
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to individual stocks,
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I don't know what to say.
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Do you irrationally hold
positions in individual stocks?
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Tell me all about it in the comments.
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Thanks for watching.
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My name is Ben Felix of PWL Capital.
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And this is Common Sense Investing.
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I will be talking
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about a new Common Sense
Investing topic every two weeks.
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So, subscribe, click the bell for updates.
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If you enjoy my Common
Sense Investing series,
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don't forget to check out the
Rational Reminder Podcast,
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which is available on Libsyn,
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iTunes, Google play, Spotify and Stitcher.
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Links in the notes.
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(upbeat music)
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