Individual Stocks vs Indexing
© Brendan Ross
The mytery of the stock market
For most people, the source of stock market returns is a mystery. Ask yourself: why does putting money in the stock market result in long term gains? This is an excellent question.
Not knowing the answer can lead to very dangerous thinking. For example, you might think that the purpose of an investment advisor is to recommend stocks for your portfolio, because choosing the right stocks is the way that people make money in the stock market. This is wrong.
Risk is the source of returns
Risk is the source of stock market returns. The greater the risk, the higher the expected return. Everyone knows that government bonds have less risk and lower returns than the stock market. Similarly, small companies have more risk than big companies, and emerging markets have more risk than developed markets. For investors willing to take bigger risks, the prices of small companies in emerging markets tend to be such that greater returns are possible.
This natural order is self-maintaining. If the stock prices of small companies in emerging markets get too high, people will take their capital elsewhere and get the same return for less risk.
Taking a ten year perspective
The US equities market has gone up in real dollars by around 8% per year since 1926, but in any single year it has jumped around quite a bit. You have to look at decades instead of years to see the 8% pattern emerge. Risk is the variations that happen in the short time frame. The more risk that you have, the more return you’ll get. In a very real sense, the source of stock market returns is fear of volatility.
When you buy a single stock, whether through a recommendation, or because it’s part of your compensation, you are taking on two kinds of risk.
Two types of risk from owning individual stocks
- Market Risk – The risk of being in the stock market in a particular asset class versus owning bonds or cash. This is Good Risk, because you can’t avoid it and you are getting paid to take it. This is the Risk that generates returns for you. Technically it’s called Systematic Risk, because it’s fundamental to the system and you can’t get away from it without lowering returns.
- Individual Stock Risk – This is the risk that a particular stock will be higher or lower than the market average in any particular time period. This is called Unsystematic Risk, and it is very bad. Fortunately it is also very avoidable. You avoid this risk through diversifying, meaning buying lots of different stocks.
Individual stock risk is uncompensated
Because diversifying can eliminate the second sort of risk, no one will pay you to take this risk. In other words, the prices of stocks do not include any compensation for holding them one at a time. Technically, the price of a stock corresponds to the Market Risk for that asset class. If you hold an undiversified portfolio, you are taking uncompensated Individual Stock Risk.
A very different stock market
The general picture we’re painting is of a stock market that is very different from one that contains some stocks that are special bargains and others that are dogs. In the picture we’re painting, the market moves slowly upward, with individual years smoothing out to make a long term trend. Within that trend, individual stock jump around like crazy.
Lower your risk for free
To get the least risk possible, you want to own many, many stocks. This way you get the market risk, but not the risk of the individual stocks. And that’s exactly what an index fund is: a way to buy all the stocks at once so as to avoid the risks of individual stocks.
Now that we understand these two types of risk, we can add a third in the middle:
- Market Risk
- Asset Class Risk – the risk of owning a particular asset class, such as Small US Companies
- Individual Stock Risk
All of the equities in an asset class tend to move around together, and they tend to move around differently from other asset classes. For example, if Large US Companies fall in value, this may not much affect Small Japanese Companies. The whole phrase “Asset Class” really just identifies a group of securities that tend to move in price together, and tend to have similar risk and return characteristics over time.
Unlike Individual Stock Risk, you can’t totally diversify away your Asset Class Risk. This is because Asset Classes contain thousands of equities, and if you want the return of the Asset Class, you have to accept the risk.
How to partially eliminate Asset Class Risk
The good news is that by owning many different asset classes, you can partially eliminate Asset Class Risk. In this way you can take some risk in owning Emerging Market Small Companies because you also own Large US Companies, and even though the first is riskier, by owning both you are reducing the risk of owning just one. Though we won’t go through the exercise here, it’s not hard to prove that you can actually have less total risk by owning 50% each of two asset classes than by owning 100% of the less risky class.
Individual investors typically make two mistakes, increasing their risk
- They don’t own enough individual equities to be sufficiently diversified
- The equities they do own are in only 1 or 2 asset classes, whereas they should be in 10 or more
Dale Domian, David Louton, and Marie Racine recently wrote “Diversification in Portfolios of Individual Stocks: 100 Stocks Are Not Enough” (The Financial Review, Nov 2007). The title says it all.
Imagine the trouble and expense you’d have trying to buy 100 stocks in each of a dozen globally diversified asset classes. Being properly diversified is an enormous challenge. Fortunately for investors, a competitive industry has grown up to create appropriately diversified index funds.
Index funds are amazingly cheap
One of DFA’s most expensive funds is Asia Pacific Small Company, with a management fee of 0.62%. Although this is less than half the expense ratio of an actively managed fund, this is still large for an index fund. If you had $1 million set aside for equities, you might put only $30,000 into this particular asset class. Do you think you could set up and manage a broadly diversified portfolio of Asia Pacific Small Companies for $186 each year?
The same thinking applies to bonds
Although we didn’t cover bonds in much detail, similar arguments prevail there as well. Most investors will want exposure to global bonds, and this is all but impossible without index funds.
Self-diversification is too hard, and index funds too reasonably priced, for any normal investor to replicate the effectiveness of index funds by buying individual stocks.