Wednesday, May 26, 2010

Risk in Buying Individual Stocks

I learned about stocks at my father’s knee. It’s hard to realize now when so many people have a stake in the stock markets that in the 1950s the percentage of households with direct or indirect stock ownership was much lower than it is today. With the advent of IRAs and 401(k) plans most working people indirectly own stocks. In 1950, individuals owned 91% of stocks; institutions (insurance companies, mutual funds, pension funds and the like) owned 9%. Now individuals own only about 30% of individual stocks with institutions owning the other 70%. As long as I have known my father, he has owned stocks – mostly individual stocks, although he does have mutual funds as well.

Let’s say you have some money to invest in stocks – we’ll say your great aunt Matilda dropped a quarter of a million bucks in your lap with the restriction that you had to invest it in stocks for the next ten years. She wants you to learn about equity investing and not so much about vacations in Aruba. After the ten years you are free to do with it as you wish.

There are two philosophies toward investing. We can summarize one as “don’t put all your eggs in one basket.” The other is “put your eggs in one basket and watch the basket very carefully.”

Every stock carries two kinds of risk: systematic risk and nonsystematic risk. Think of systematic risk as the rising tide that floats all boats (or the lowering tide that drops them all). As an individual, you can’t get rid of systematic risk, although you can hedge it to some extent. Lessening systematic risk is government’s responsibility – and as evidenced by the latest financial crisis they still do a miserable job.

Nonsystematic risks are the facts and circumstances unique to a particular company. For one company the CEO is a one-of-a-kind genius, and he lives to be a thriving ninety. For another the same type of genius dies the day after you buy the company’s stock. Or the company has an oil well disaster in the Gulf of Mexico. While an event such as an oil well disaster in the Gulf may affect the entire world economy (and therefore be a component of systematic risk), that risk is unique to companies who drill for oil. It is not a nonsystematic risk for everyone else.

Financial theory suggests you should be appropriately rewarded for taking systematic risk, but should not be rewarded for taking nonsystematic risk. Why? Because if you buy all the world’s stocks in the same proportion as their market value, you have essentially eliminated your nonsystematic risk. Therefore, to the extent it is possible to buy the world stock market, no one should be willing to pay you more to take on the risk of owning one particular company when you could own the world.

It doesn’t work quite like that. For example, you can't own a slice of privately held companies. Some foreign governments own corporations residing in their country, which leaves you and me out. There are, however, mutual funds that do a sufficiently good job purchasing a representative sample of the available securities around the world to essentially eliminate nonsystematic risk.

So why buy an individual stock rather than the world? Because you expect it to go up more than the world market. Why should that happen? Because you have a better understanding of the value of a company than the rest of the world (who through their purchases and sales have set the price for the stock.)

Now let me ask a question? How many hours a week do you spend researching individual stocks? And given that allocation of your time, how do you expect to outsmart people earning six and seven figure bonuses who work 60, 70, 80 or more hours a week doing this analysis?

Unless you know something the experts don’t because you have inside information (but not inside information that makes it illegal for you to buy the stock) you are placing a bet (not making an investment) that the stock market is wrong and you are right. I’m not a big fan of those odds.

Oh wait you don’t have to pick stocks by yourself. With your $250,000 a stock broker (slap my wrist, we call them financial advisors now) will be happy to make recommendations based on the work of their “proprietary” research staff. Stock brokers are salesmen – they may have initials after their names and talk a good spiel, but they only make money if you buy or sell something. They make more money when you frequently do both. And the research staff? Let me ask two questions: (1) If they’re so good, why are they not quadrillionaires? (2) When did they publish their findings and why hasn’t the rest of the market already followed their advice and bid the stock up to its fair value?

The chart below shows the results of a 1987 study on diversification. To diversify away a large portion of the nonsystematic risk, experts suggest you need to have at about 30 stocks in your portfolio, and you need to make sure to spread them around the various market segments. It takes a lot of time and a lot of smarts to do this well. Oh, and you need a lot of money to buy thirty different stocks.

I don’t have the smarts or the time to try to get rid of nonsystematic risk through individual securities. Nor do I think a financial advisor is the way to go. I let mutual funds do the work for me.

On Friday we’ll look at index versus actively managed mutual funds.

~ Jim

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