Why Owning Individual Stocks Can Be Riskier Than You Think

Investing in individual stocks can feel exhilarating, especially when media narratives champion the next big winner. However, the odds are stacked against the average investor who lacks specialised skills to identify long-term outperformers.

Empirical data repeatedly shows that a small number of stocks drive the majority of wealth creation in markets. Let’s dive deeper into the risks of concentrating on individual stocks and what remains the key to sustainable long term compounding success.

The Odds Against Stock Selection

A comprehensive study in 2023, analysing 64,000 listed global stocks, revealed that 55.2% of U.S. stocks and 57.4% of international stocks failed to outperform one-month U.S. Treasury bills over their lifetime.

Even more striking, the top 2.4% of stocks accounted for all $75.7 trillion of global net wealth creation from 1990 to 2020. These findings highlight the concentrated nature of stock market returns: a few massive winners offset the many underperformers or outright losers.

Closer to home, an analysis of BSE 500 (March 2002 to September 2023) showed:

• Around 65% of stocks underperformed the BSE 500 Total Return Index (TRI).
• Over longer horizons, the disparity grows as outperforming stocks pull the index higher while laggards weigh down buy-and-hold portfolios.

In essence, betting on a single stock (or a narrow set) is like gambling in a game where only a handful of players win big while the rest lose or merely survive.

Understanding Skewness in Stock Returns

Stock market returns exhibit a positively skewed distribution. This means:

• Most stocks generate modest or negative returns.
• A small percentage of stocks generate extraordinarily high returns, which inflate average market returns.

For example, consider a cricket analogy: In the 2023 World Cup match between Bangladesh and South Africa, Mahmudullah scored 111 runs, while the rest of the team collectively managed far less. The average runs per player (~20) were pulled up by Mahmudullah’s stellar performance, masking the poor showing of the majority.

Similarly, in the stock market, multi-baggers (stocks with outsized gains) inflate overall returns. However, the median return (what most stocks deliver) often lags behind the average, underscoring the difficulty of picking winners consistently.

Risks of Concentrated Portfolios

Investing in one or a few stocks amplifies the risks of large drawdowns. Historical data from the BSE 500 shows:

• Over a 10-year period, more than 70% of stocks experienced drawdowns greater than 50%.
• Many stocks saw drawdowns exceeding 75% during major market events, such as the Global Financial Crisis or the COVID-19 pandemic.

If your portfolio consists of only a few randomly chosen stocks, the likelihood of suffering catastrophic losses during market downturns is alarmingly high. Unless the stocks you have selected are based on a fundamentally oriented screening and make their way into the top 30% of performers, diversification remains the antidote to such concentration risk.

Why Diversification Works

Diversification doesn’t just reduce the chances of picking a dud stock; it also increases your exposure to potential multi-baggers. For most investors:

1. Risk Management: A diversified portfolio smoothens the impact of underperforming stocks and minimizes the probability of extreme drawdowns.
2. Compounding Benefits: Holding a broader set of stocks ensures you capture the compounding effect of outperformers over time.
3. Reduced Behavioral Pitfalls: Concentrated portfolios often lead to emotional decision-making, as investors react to volatility. Diversification helps mitigate this.

The Cambridge Wealth Approach: Intelligent Diversification

We leverage a data-driven, systematic approach to build portfolios that strike a balance between risk and return:

• Deep Market Insights: We identify funds with exceptional track records, focused on dynamic sector allocations and exposure across markets to maximise opportunity while minimising risk.
• Holistic Portfolio Design: Portfolios are carefully build to integrate multi-asset strategies that cater to your evolving life stages and specific financial aspirations.
• Agile Portfolio Adjustments: Our systematic approach includes real-time monitoring and data-backed rebalancing, ensuring portfolios stay resilient in shifting market conditions.

This process ensures your investments are both protective and growth-oriented for sustained compounding success.

By combining the breadth of opportunities with a disciplined investment process, we help investors maximise their chances of long-term success.

Key Takeaways

1. The majority of individual stocks underperform benchmarks like the BSE 500 or even risk-free instruments like Treasury bills.
2. Stock market wealth is disproportionately driven by a small percentage of outperformers, making stock-picking a high-risk strategy for most investors.
3. Diversification is essential to reducing risk, capturing market returns, and avoiding severe drawdowns.
4. Systematic and disciplined approaches, like the one we inculcate at Cambridge Wealth, provide a reliable framework for navigating the complexities of equity investing.

For individual investors, staying diversified isn’t just a strategy—it’s a necessity. The next time you’re tempted to put all your money into the “next big thing,” remember: the odds are rarely in your favor.