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Today's Commentary: 04.22.05
Note from Editor: Guest columnist Larry Swedroe joins us for a look at the mindset needed for buying individual stocks. Enjoy!

Speculating Versus Investing:
The Buying of Individual Stocks
by Larry Swedroe

When it comes to investing, we need to distinguish between two very different types of risk, good risk and bad risk. Good risk is the type that you are compensated for taking. The compensation is in the form of greater expected returns. For example, equities are more risky than fixed-income investments. Therefore, equities must compensate investors by providing greater expected returns to attract investors. The risk, of course, is that the expected does not occur. Similarly, the stocks of small-cap and value companies are riskier than their large-cap and growth counterparts. And just as the risk of owning equities cannot be diversified away, the risk of owning small and value stocks cannot be diversified away.

Therefore, small and value stocks must also carry risk premiums. In addition to the risk of equities and the risk of small and value stocks there is a third type of equity risk‹the risk of an individual company (think of Merck and what happened to its stock when they had to pull Vioxx off the market). And since this type risk can easily be diversified away, the ownership of individual stocks is one that the market does not compensate investors for taking. Thus it is bad (uncompensated) risk. And because investing in individual stocks involves the taking of uncompensated risk, it is more akin to speculating than investing.

The benefits of diversification are obvious and well known. Diversification reduces the risk of underperformance. It also reduces the volatility and dispersion of returns without reducing expected returns. A diversified portfolio, therefore, is considered to be more efficient than a concentrated portfolio. The results of the last several years illustrate this point very well.

The year 2004 was a very good one for the market. The market, defined as the CRSP (Center for Research in Security Prices at the University of Chicago) 1-10 Index returned 11.9 percent. Despite the strong year for stocks, fully one-third of stocks that were in existence the entire year provided negative returns. And the average loss of those stocks was 25 percent. And even that figure understates the risk of individual stock ownership as a significant number of stocks disappear each year through bankruptcy or delisting‹and they almost certainly provided even worse returns. Thus over one-third of all stocks that were available to invest in underperformed the market by an average of at least 37 percent.

Taking uncompensated risk can be very expensive.

We find very similar results when we extend the time frame to the ten-year period 1995­04. While the market returned 12.0 percent per annum, 16 percent of the 2,781 stocks that survived the period lost money, with average loss being almost 10 percent per annum. Those stocks underperformed cash in a mattress, and underperformed the market by over 20 percent per annum. Keep in mind that as we extend the time frame, the survivorship bias in the data increases.

Similarly, in the decade of the 1990s, with the market returning over 18 percent per annum, one of the greatest bull markets of all time, 22 percent of the 2,397 U.S. stocks in existence throughout the decade had negative returns.

While individual stocks offer the possibility of both market-beating returns, they also offer the potential for disastrous results. As you consider these two potential outcomes keep in mind that investors are on average highly risk averse; and they become more risk averse the larger the amount involved. A great illustration of the risk averse nature of individuals is the game of "Outfox the Box." In this game you are an investor with the following choice to make. You are shown nine boxes, each representing a rate of return you are guaranteed to earn for the rest of your life on your assets.

You can either choose to accept the 10 percent rate of return in the center box, or you will be asked to leave the room, the boxes will be shuffled around, and you will then choose a box, not knowing what return each box holds. You quickly calculate that the average return of the other eight other boxes is 10 percent. Thus if thousands of people played the game and each one chose a box, the expected average return would be the same as if they all chose not to play. Of course, some would earn a return of negative 15 percent per annum (ending up very poor), while others would earn 35 percent (ending up very rich). This is like the world of investing, where if you chose a stock you might be lucky and earn as much as 35 percent per annum; or you might be unlucky and lose 15 percent per annum. A rational, risk-neutral, or risk-averse investor should logically decide to "outfox the box" and accept the average (market) return of 10 percent.

In my years as an investment advisor, whenever I present this game to an investor, I have never once had an investor choose to play. While they might be willing to spend a dollar on a lottery ticket, they become more prudent in their choice when it comes to investing their life's savings. The reason is that for the vast majority of individuals the strategy is not to retire (or die) rich, but to avoid retiring (or dying) poor.

Individual stock ownership provides both the hope of great returns (finding the next Microsoft) and the potential for disastrous results (ending up with the next Enron). Since investors are not compensating for taking the very significant risk that the result will be a disastrous one (just ask investors in once great companies such as MCI, Polaroid, Xerox, etc.) the rational strategy is not to play. Unfortunately the evidence is that the average investor, while being risk averse, doesn't act that way‹they fail to diversify. That is the triumph of hope over wisdom and experience.

Given the obvious benefits of diversification, the question is why don't investors hold highly diversified portfolios? The following is a brief list of some of the reasons:

• The vast majority of investors have not studied financial economics, read financial economic journals, or read books on modern portfolio theory. Thus they do not have an understanding of how many stocks are really needed to build a truly diversified portfolio. Similarly, they don't have an understanding of the difference between compensated and uncompensated risk. The result is that most investors hold portfolios with assets concentrated in relatively few holdings.
• Prof. Richard Thaler of the University of Chicago and Robert J. Shiller, an economics professor at Yale, note that "individual investors and money managers persist in their belief that they are endowed with more and better information than others, and that they can profit by picking stocks." This insight helps explain why individual investors don't diversify: They believe that they can pick stocks that will outperform the market.
• Investors have the false perception that by limiting the number of stocks they hold they can manage their risks better.
• Investors gain a false sense of control over the outcomes by being involved in the process. They fail to understand that it is the portfolio's asset allocation that determines risk, not who is controlling the switch.
• Investors confuse the familiar with the safe. They believe that because they are familiar with a company, it must be a safer investment than one with which they are unfamiliar. This leads them to concentrate their holdings in a few companies.
• Because investors confuse information with knowledge they don't recognize the simple investment truth that, as legendary investor Bernard Baruch stated, "something that everyone knows isn't worth knowing." The failure to understand this leads to a false sense of confidence‹leading, in turn, to a lack of diversification.

How Much Diversification is Needed?
There is a great deal of academic research on the subject of how much diversification is needed to keep what is known as tracking error to an acceptable level. In this case, tracking error refers to the variance between the performance of the entire asset class to the performance of a subset of the asset class. The research has found that to keep tracking error to an expected level of 5 percent (a level many investors would likely find unacceptably large), an investor would have to own approximately one hundred different individual stocks from one specific asset class. Thus building a portfolio of individual stocks that is globally diversified across perhaps eight to ten equity asset classes would be well beyond the resources of almost all individual investors. On the other hand, it can be easily accomplished through the purchase of index funds, ETFs, or passive asset class funds.

Investors who hold large percentages of their portfolios in individual stocks are either directly or indirectly asserting that they believe they can beat the market. Otherwise, they would diversify their portfolios and accept market returns, less the cost of investing. They also choose to accept risk that can be diversified away. For shouldering this diversifiable risk, they should not expect to be compensated with higher returns. But they should expect much greater volatility. This is why the purchase of individual stocks is more akin to speculating than it is to investing.

Today's Commentary: 04.18.05
The Right and the Wrong

Even as the markets retreat under the nearest rock looking for any hiding place that will provide reasonable shelter from the impending storm, many on Wall Street and beyond are scratching their heads in bewilderment. And that leads to the obvious questions: who is right and what went wrong?

Respectful and decent people don't tell their peers when they are right. They just assume the mantle of expertise in silence and do so knowing that when it comes to financial topics, such monikers are often short-lived.

Among those right were the select few who had faith in the lingering effect of oil's remarkable run-up. Even if those barrel prices plunged, it is the end product that fuels the ire of middle America acting like a tax on our indomitable consumptive ways. Filling up has turned into an act of increased indebtedness. No one can plunk down the kind of cash needed to top off those tanks at these record gasoline prices. Whipping out the plastic at the pumps has replaced whipping out said card at Wal-Mart which has created new worries.

So we have slowed our spending to compensate for higher gas prices. That means worries about inflation do not necessarily jive with those changes in consumer sentiment. With the Fed supposedly watching this sequence of events unfold from their lofty tower, the new parlor game is guessing the direction of the next Fed meeting. Although I expect attempts at predicting Greenspan and co. might find you on the wrong side of the wager no matter the outcome. Without inflation investors correctly understand that profits will slow. Without profits, investors will look for yield. This shift will take money designated for growth into investments designed to deliver income.

With the Consumer Price Index excluding food and energy on the move up, wages looking weak and the "measured" approach the Fed is using to slow an economy that is slowing all by its lonesome, all eyes are on the Producer's Price index due out on Tuesday.

Not that the report didn't already have a certain gravity before but it now may be the best indication of whether commodities have leveled off at the wholesale level allowing some balance in pricing at the supplier level. Pricing at the producer level has been quite good of the last several years. Passing those prices on to the consumer has not been as easy. The PPI has been a negative force on bonds in the short term in the past but has been a reassuring force in terms of the long bond and its anticipation of inflation.

The long bond yields may be the key for believing that inflation will be nicely contained. Unless, of course, the PPI is off the charts. Many expect an increase over February's number of 0.4% to a March reading of 0.7% excluding food and energy.

Paul Volker has become the oracle of the "I told you so" crowd as he openly suggested that the ice we are standing on is not strong enough to support our bullish optimism let alone be able to hold our desire to buy any and everything foreign, even if those goods might have been made by American companies. I only mention that because in reality 48% of the $61 billion trade deficit is actually going to US companies using foreign labor to make products for sale to Americans. The same consumer who points an accusing finger while they whine at the Chinese and Asian producers. They are only filling a niche.

Volker's concern aside from our appetite for spending and our anorexic savings rates is that he wants us to understand just how much we are borrowing. We are now in debt to the point where we have put the world in jeopardy as we siphon the savings of saver nations in ever greater amounts. With only so much available capital to be had on the open market, the gluttonous US of A has tied up over 80% of the available cash the world has to lend.

With these warnings of trouble ahead and evidence that it may have taken hold in the marketplace, investors should be cautious. Bewares are in order as the new sayers who cite trends that are similar to presidential cycles past and seasonal adjustments to natural patterns begin to surface in print and on air.

This is not your father's economy. Nor is it the economy of your grandfather. In fact, Mr. Volcker who is old enough to be grandfatherly, suggests that he has never seen anything quite like it. Administrative insouciance accompanied by misguided stimulus - which continues unabated even as the House once again suggests the elimination of a fair tax on estates that does not in fact take the family farm down with a single death and with the signing of the middle class death knell concerning bankruptcy - and lack of fiscal and financial discipline seems almost incomprehensible to the former Treasury Secretary. Does no one but he notice? He will be made into a Cassandra in the coming weeks at the Trojan Horse is pulled to the doors of the kingdom.

Instead of looking for comfort among those that are wont to say, "I told you so" or by those who see the future as one with clear choices and inevitable consequences, investors have instead retreated. They are finally beginning to believe that the economy can no longer sustain enthusiasm, risk and speculation without paying some steep and painful penalties.

Ambrose Bierce once wrote in the Devil's Dictionary an market apt definition of a cynic. Rather than stay with the conventional definition of one who sees everyone as selfish, Bierce suggested that a cynic is a "black leaguer who see things the way they are rather than the way they ought to be." Failing to listen to sage advice and the obvious warnings will vet out those who are right and those who are wrong - perhaps more clearly than ever before.

The Blue Money Report
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