So I’m primarily a long-term investor with some interest in the mechanisms of the markets and economics in general. While I do have some ambitions of seeking financial independence a bit earlier than social security would support, my interests in the market tend to be driven more by curiosity than practicality. I have an MBA, but to be honest what I learned there was very introductory and superficial. I find markets interesting.
Lately I’ve been reading a book called “Stocks for the Long Run” by Jeremy J. Siegel. The book is essentially a long historical argument for why equities have rewarded patient investors despite all the short-term volatility, crashes, and noise of the market. I’ve also found it’s been a good book to deepen my understanding of equity markets in general. Historical returns may not predict future results – but it’s also the only data we have.
One insight I found particularly helpful in re-wiring some of my intuition about stocks was in chapter 5, where Siegel addresses how most stocks actually have under-market returns, and why it’s so difficult to make market returns in a non-diversified portfolio.
The average investor believes that if he or she picks one or two of those stocks at random, on average, they will realize the average rate of return, which has been almost 7 percent per year after inflation.
This was me. I always believed that the reason stock picking was bad came down mainly to two things: First, you were taking on a lot more risk. The market is volatile, but individual stocks can be even more volatile, and the market isn’t going to pay any additional risk premium for hyper-focusing in on just one stock when you could buy the market as a whole. Second, for most people it tends to be a form of emotional investing. Big-name stocks tend to be traded based on feelings, feelings often shared by lots of other people and thus most people tend to be emotionally drawn to some of the most over-priced stocks. In the short run riding a higher price to earnings ratio may help you enjoy the ride, and if the market is doing well generally then making even a below-market return may feel like a success even when it’s not. Individual stock picking is an area where it’s very easy to be ‘dumb money’.
Well, while there may be some merit to all the above, it turns out there’s also a mechanical reason why picking individual stocks is statistically less likely to generate an above market return which Siegel lays out in an example.
Let’s say, hypothetically, that the market’s expected return is 0% for the period. Let’s say a ‘good’ outcome for the year is +10% and a bad outcome is -10%. Let’s ignore inflation in our very simplified example and say we’re going to run for 2 years.
If we invest $100 in our stock there are only 4 possible outcomes:
- Good Year -> Good Year = $110 -> $121
- Bad Year – > Good Year = $90 -> $99
- Good Year -> Bad Year = $110 -> $99
- Bad Year -> Bad Year = $90 -> $81
So essentially, the arithmetic average ending value is $100, but the median outcome is only $99. Three of the four paths leave you below the starting point, even though the average is held up by the one strong outcome.
Fail to include those exceptional winners in your stock picks, and you’re going to end up picking below-market.
Now, obviously this is an oversimplification – the baseline is market, not 0, ‘good’ and ‘bad’ are sliding scales, and on average actually slightly less than half of stocks actually outperform the market on any given year (so it’s worse than this looks). But the notion that over time the market’s value becomes highly concentrated and that in order to win you don’t just have to pick the best half of the market but rather successfully find the few winners, remains.
I realize I’m discovering old news here. In fact I found another blog (no affiliation – found them on google) which extrapolates this out using real data and shows that over a 20 year period 90% of companies in practice will end up underperforming their market benchmark. Even over only a 5 year period, depending on sector, you’re looking at 84% on all domestic funds which underperform (less in some sectors – because some sectors did better overall).
That puts you in a pretty tough bind:
- If you pick a single stock and hold, your chances over the long term of that stock consistently outperforming the market get pretty bad.
- If you try to jump around between individual stocks to find the next winner, then the temptation to end up following the market (buying high and selling low) will be extreme.
It’s not a great bind to be in for a longer-term investor.
And this is how I realized individual stock picking was even worse than I had assumed. I already understood the risks of added volatility and the temptations of emotion, but hadn’t really thought through the mechanical issues around concentration and how large a class of ‘bad’ options that creates. If you don’t hold that relatively small number of exceptional winners, you may never actually receive the return you think “the market” provides.
I’m still interested in looking at things like sector tilts, but individual stock picking now feels less like an interesting calculated risk and more like a roulette table I don’t need to sit down at.
Image: GenAI Image using Midjourney 8.1 with the prompt “A stock market chart showing stocks performing poorly and crashing. In front of them a roulette wheel/table in the foreground, Light colored background. –p –ar 3:2”.
