The more I learn about investing, the more I realize it is about controlling risk and accepting the returns you get than it is about chasing the returns you want and accepting the risk you get.
It is a well-known general rule that you can't get high returns without taking on high risk. CDs simply don't have the expected return of microcap stocks. It is important that you take on enough risk to reach your goals by investing in assets that generate a significant real (after-inflation) return such as stocks, real estate, and small businesses. At the same time, you don't want to take on any more risk than you need to. If you receive a $5 Million inheritance from your rich aunt, you don't need to invest in the stock market, so you probably shouldn't, at least with any significant percentage of your portfolio.
Types of Investment Risk: Uncompensated and Compensated
However, there is a difference between compensated risks and uncompensated risks.
A compensated risk is a risk, which, if you take, will increase the expected (not guaranteed) return of your portfolio.
An uncompensated risk is a risk that doesn't increase, and may even decrease the expected return.
Diversify Against Investment Risk
Why would anyone ever take an uncompensated risk? Good question. The truth is, you shouldn't if you don't have to. Nobody does it knowingly. So how do you avoid it? Diversification. An uncompensated risk is a risk that you can diversify against.
Examples of Uncompensated Risk
Buying individual stocks is like diving alone. Lots more risk and not nearly as fun.
#1 Investing in Single Stocks
For example, you can invest your portfolio all in IBM stock. Now, let's imagine IBM has about the same expected return as the overall stock market, say 5% real per year.
Now, is it more risky or less risky to invest in just IBM or to invest in all 6000+ stocks in the US market? Of course, it's a greater risk to invest in IBM. So shouldn't the expected return of investing just in IBM be higher? Nope, it doesn't work like that. Because you CAN diversify against that higher risk, you don't get paid to take that risk. You get paid for taking on market risk, but not to take on the higher risk of investing in a single company. If you were paid to take on that risk for every little company in the stock market, then the overall stock market return would, of necessity, have to be higher.
#2 Investing in Single Bonds
You can buy a bond from GM. If GM goes bankrupt and can't make the interest payments, or worse, even pay back your principal, you're screwed. Say the GM bond yields 6%. Are you better off buying 20 different bonds from 20 different companies all yielding 6% or just buying the GM bond yielding 6%? Of course, you want all 20. Same expected return, less risk.
#3 Other Examples of Unnecessarily Risky Investing
Other examples of uncompensated risk are buying a single investment property, or buying all your properties in one geographic area. Investing in actively managed mutual funds is also taking on uncompensated risk. You don't have to run the risk of manager underperformance because you can diversify against it through low-cost index fund investing to reach your financial goals.
We all know someone who put all his eggs in one basket and paid for it. It might be a grandparent who lost the farm, an uncle who lost his pension, his job, and his 401K all at once at Enron, or a colleague who got cleaned out investing 80% of his portfolio in Tech Stocks in the 2000-2002 bear market. Don't be that guy. Diversify your portfolio so you don't take on any uncompensated risks.
What do you think? Do you take on uncompensated risk? Why or why not? Comment below!
I finally understood what “Uncompensated Risk” mean, i had understood what “Risk” meant, but the explanation in this page helped me a lot to understand “Uncompensated Risk”.
Reading your blog is my favorite pastime now. 🙂
May GOD bless you, Thanks for all the posts.
You’re welcome. Glad to see you’re enjoying some of the posts I wrote when no one was reading them! As you can seen, there aren’t nearly as many comments on these old ones!
Nice and clearly written. It makes a lot of sense. Thank you.
This line seems prophetic and good to remember: “Other examples of uncompensated risk are buying a single investment property, or buying all your properties in one geographic area.”
I agree, this sentence was a great example of delivering what uncompensated risk truly means.
Hi,
When i read this, it was a bit difficult to grasp, so i just replaced stocks with bonds to easily understand myself.
say bond issuer IBM is issuing bonds for 2% and you want to buy that with all of your money, IBM is not willing to pay more for you, as they can always get other people to take their bonds at 2%, where as you are taking uncompensated risk by putting all money in IBM bond. The reason you wont get compensated is that you can diversify away your risk(of IBM going bankrupt) by buying bonds from other issuers like Apple.
The only benefit one get for not diversifying is ease of handling(i.e managing just one bond instead of many), but one can pay a small fee and just buy a ETF and get the same simplicity. Thus it is not worth the risk of concentrating all money in one bond/stock for the sake of simplicity.
The only time(time will tell, if i am wrong) it may not be worth diversifying is when you are putting all your money in US government bonds.
I does seem logical that the expected return of a random stock is equal to its parent market. But, for long term (greater than 10 years), buy and hold investors, might there be some reason to believe that certain segments (eg tech) will outcompete “legacy” segments (eg physical stores)? This implies the heretical: that people can predict the future. But I wonder if there is evidence that that might be true over longer time periods. What do you think? (Maybe I’m just trying to justify wanting to gamble on individual stocks for fun.)
Surely some segments will out perform the overall market and some will underperform. If your crystal ball will show you which ones, invest your money only in those. But even if that is the case, you can lower uncompensated risk by using a sector ETF instead of individual stocks.
Thank you! That makes sense! I’ll look for some low-cost ETFs!
Why just reduce uncompensated risk when you could eliminate it entirely?
I guess the honest answer is that I think I have a reasonable chance of predicting the general shape of the future over 15 years. My wife and I discussed: We are thinking 5-10% bet in a low cost tech ETF. We might be wrong. But there doesn’t seem to be as much evidence specifically against long term, non-total-index bets. The inefficiency of stock picking seems related to both trading costs and uncompensated risk. A tech ETF might negate both of those – if I’m right that I have a reasonable crystal ball. But the only thing my wife and I could agree on was tech outperforming over 15 years.
If you can accurately predict the future in any way, shape, or form, you should be investing a lot more money than your own.
Hard to mess too much up with 5-10% though.
I suggest you write down all your bets and take a look at it in a few months and a few years. You might be surprised how cloudy your crystal ball is. I’ve done this exercise. I’m positive I have no idea where the market or interest rates will be in the future, much less which sectors or individual stocks will outperform.
Remember that the challenge is not predicting that the tech industry will continue to grow. The challenge is predicting when the prices of tech stocks are low compared to their future prospects. It is not enough to be right that the industry will grow. You have to be righter about the value of the stocks than is the market as a whole. Only then can you know when tech stock prices are likely to give you a good return.
I recall a lot of people were very enthusiastic about .com stocks about 8-9 years before the recession. Did not work out well…
Exactly. Or as Larry Swedroe would say (or something similar) – anything you know about tech stocks, including expectations, is public knowledge so is already priced into the market. So the price of any stock will only change if something unexpected happens, a surprise, which by definition is unpredictable.
Thank you so much for the tips! We have our investing plan written down. I may end up abandoning sector ETFs since I can’t autoinvest into them from my 401k. But maybe we’ll put a little in play just for fun. Those P/E ratios are pretty high…
I do think I can predict the future – but with a high degree of uncertainty… 😉
I was reading one of the books Jim recommends and I wanted to post this for Timothy because it sounded like he was pretty confidant he knew where the market was heading in tech stuff.
“If you get 256 people into a room and give them each a coin to flip, the odd are that half of them—128—-will flip heads on the first try……Of those 128 winners, 64 will flip heads on the next go-round as well. Twice running. Not Bad. 32 will flip heads three times in a row, 16 will flip heads four times in a row, eight will flip heads five time in a row, four will succeed six times in a row, two will rack up an incredible seven straight successes, and one—one out of all 256 in the crowd–will flip heads eight times in a row. What talent! What genious! What nonsense…..His chances are 50-50. He is a statistical probability…In any given year, half the stock-market players will beat the average and half will do worse”-Andrew Tobias (The Only Investment Guide You’ll Ever Need)
I think what I am trying to say is your”reasonable chance of predicting the general shape of the future over 15 years” has a about a 50% of being correct. That is still better odds then Roulette wheel or Black Jack.
Thank you, Ben!
Yeah, I don’t have a crystal ball but I do think that tech will play an only larger role in our lives.
The question is whether it is possible to capitalize on that guess.
It seems like buying a tech sector ETF isn’t exactly like flipping a coin as there are many other bets to make. However, Bogle himself, in “On Mutual Funds”, suggested that certain sector bets (he mentioned healthcare) might be reasonable over the long term.
However, now that the US stock market is dominated by tech stocks with high valuations, I suspect that most of my prediction that the future is tech has already been folded into the market. My thinking was that my long-term outlook might allow me to squeeze some returns from a relatively under-valued tech sector but – in looking at how richly things are valued – even I don’t have the guts to make that bet now.
Maybe the end of high tech sector valuations is nigh.. I’d be sad to be left holding an undiversified bag.
Lots of “maybes” in that comment, like there should be. I don’t know the answers, so I just buy them all and that has been good enough to reach all my goals when combined with discipline, a high income, and a decent savings rate.
If you think investing in the tech sector is a fantastic idea and you can guess the future then you’re probably should flash back to the year 1996 when your tech bet would have made you a genius for four years and made a bunch of money until 2000 when the NASDAQ dropped 75% and other individual tech stocks went bankrupt. So good luck betting on tech in 2019 when tech has Outperformed for much of the past decade and when the Tech sector is up around 40% for the year. Sadly you likely missed that bet in this market cycle. The good news you will probably get another chance someday. A smarter bet today would be to find some forlorn Sector of the market that has performed terribly for years, invest in it , tell your friends and have them tell you that you are an idiot and that the smart bet is in tech. That’s likely where the good returns will be eventually. Now you just have to find it. And if you can’t do that diversify and buy the whole market. Best of luck.
Dr. D,
Am reading this quite late (in more ways than one) as my wife and I took on uncompensated risk by moving to TX to build a ranch. It became a trying experience (roads, utilities, home, equipment, and a few cattle) and ended up costing very much more than we anticipated. But it was too late to bail, so we stuck it out for 4 years. I was able to find PT work which helped significantly, but in my small town PT work in my specialty has dried up and now faced with no income (SS and RMDs aside) we have to sell. It has been a very tough lesson for us both, and a timely sale may not be forthcoming.
I have let my wife down and that is not a fact that is easy to live with – I have moved what we have left to Vanguard, and am using their low cost advisor for the first year. Both of us are determined to become more knowledgeable in financial matters, as I prepare her for the future.
Thanks for all you have done and continue to do,
Dr. K
I’m sorry to hear of your travails.
That’s not the usual way I use the term uncompensated risk, but I suppose it could apply in some ways.
You made a comment of not needing to invest a 5 mil inheritance in the stock market. What would you do instead? Thanks and looking forward to WCI 2020.
Depends on a lot of factors, so hard to say. Not to mention I apparently said that 8 years ago and have no memory of what I was thinking when I wrote it.
He is talking about having a large portion of the money invested in something unlikely to have potential risks that could cause you to no longer be financially independent. Once you are financially independent you can decrease your risks. For example, you could have a 50% allocation in stocks and 50% in bonds or even 100% in bonds if you want to be extremely conservative (I don’t recommend that). That should reduce your risk sufficiently to remain financially independent. CDs and Money markets are other options. You could also diversify the portfolio a bit into real estate through REITs or even syndicated real estate investments. I think his point was about limited risk via diversification more than eliminating the market completely.
Surely what WCI might do with a $5M windfall wouldn’t be good advice for the vast majority of his readers.
Financial planner advice would be based on age, cashflow, assets, debt, expected expenses, etc. Long list. My only “standard” advice for most people would be doing nothing for at least six months. Preferably a year. Let it sit in a nice boring bank account and get stale before making any investment decisions. That’s the same advice that people selling their business for large sums get from reputable brokers to avoid hasty bad decisions.
“Now, is it more risky or less risky to invest in just IBM or to invest in all 6000+ stocks in the US market? Of course, it’s a greater risk to invest in IBM. ”
I really like the idea behind this post. It’s an excellent way of thinking about risk. That first sentence could easily be a entire post by itself. It’s not at all obvious why and I’d bet many readers wouldn’t even agree with the basic idea.
Listen to Bernstein and Swedroe-when you have won the game cash out(or at least enough to live off)
the distribution phase is quite different from the accumulation phase
Actually, when U.S. investors buy international stock, they are taking on currency risk, which is uncompensated. Generally, they do so because they believe that the diversification benefit is worth the currency risk, but it is still an uncompensated risk.
Perhaps the uncompensated risk is NOT investing internationally, because their home country/currency risk could be diversified away by buying stocks in other countries/currencies.
There is a price to be paid for international diversification in the form of uncompensated currency risk plus higher taxes. To the extent that the benefit of diversification is worth those cons is up to the individual investor.
Why higher taxes? You get a foreign tax credit.
To my knowledge, the foreign tax credit is only applicable if the international stock is held in a taxable (i.e. brokerage) account and not a tax-advantaged account; otherwise, the foreign tax credit doesn’t work. That might not be much of an issue for many readers of this blog though.
Correct.
This post explains clearly an important reason why individual stock purchase isn’t the way to go.
But it is a little too strident in stating:
“Other examples of uncompensated risk are buying a single investment property, or buying all your properties in one geographic area. Investing in actively managed mutual funds is also taking on uncompensated risk.” and
“don’t take on any uncompensated risks.”
There are times over the years where I owned single investment properties, properties in one area, and managed funds. As long as the buyer understands what and why they are buying it may make sense.
There are two schools of thought:
# 1 Don’t put all your eggs in one basket (diversify)
# 2 Put all your eggs in one basket and watch it very closely
Both probably work fine. But what you don’t want to do is a combination of the two- putting all your eggs in one basket and not watching it at all. I would argue you can’t really watch a publicly traded company closely enough to justify a major investment. But your own small business or apartment complex? You can know that business better than anyone else and really keep an eye on it. Is there still some risk there that you could diversify away? Of course, but the other benefits may outweigh it. For example, WCI, LLC is a terribly undiversified, but nobody knows it better than me.
A man named Warren Buffett once said:
“We believe that a policy of portfolio concentration may well DECREASE RISK if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.”
It only takes roughly 20 stocks to get close to similar levels of idiosyncratic risk of the S&P500. Often the benefit of “diversification” is vastly overstated. Not only that, the people usually referenced tend to have low levels of financial literacy. However, a “diversified” portfolio still has other risks making it not diversified – such as fat tail risks. Referencing the weakest points of the opposing side using those who have low levels of financial literacy as an example is not a level debate. A level debate uses the strongest of both sides. While I agree there is a minimum level of diversification, it’s clear there is more to this discussion. As long as one can prove skill over luck alongside extensive due diligence with evidence that stands up against a strong devil’s advocate, it is fine – and preferable – to have a concentrated portfolio.
Well, that’s fine if you are as smart as Warren Buffett and can do it successfully. Which is why Buffett advises investors to buy index funds.
You need a lot more than 20 stocks in the US market to adequately diversify away non systemic risk. More like 55 in good times and 110 in bad times. Hundreds more in international markets. The more concentrated portfolio you have the less statistically reliable outcome you will get. You’ll have a wider dispersion of returns, which on average, will be less than a more diversified portfolio because of the skewness of stock returns. One of the reasons indexing works.
https://mutualfunds.com/expert-analysis/portfolio-diversification-how-many-stocks-are-enough/
The reason why Warren Buffett also doesn’t follow his own advice and doesn’t believe in investing his massive cash pile in VTSAX – he believes the average investor is ignorant:
“diversification is protection against ignorance. It makes little sense if you know what you are doing.”
His quote already showed that risk is reduced beyond averages and why. You are using the average who are ignorant investors, according to Buffett, and your definition of what is “optimal” depends on your school of thought on volatility, but volatility is a flawed measure of risk to focus on solely – it’s nice, “mathematical”… and wrong.
“Volatility is not a measure of risk. And the problem is that the people who have written and taught about volatility do not know how to measure — or, I mean, taught about risk — do not know how to measure risk. And the nice about beta, which is a measure of volatility, is that it’s nice and mathematical and wrong in terms of measuring risk. It’s a measure of volatility, but past volatility does not determine the risk of investing.”
I look at investors that have significant skill over luck. You look at investors on average which Buffett believes are ignorant. Very different mentality.
The important thing is to place yourself correctly. Should you put yourself in the skilled bucket or the average bucket? In my experience, my returns are better when I put myself in the average bucket. YMMV.
I certainly do not agree that you should not buy single stocks because they represent “uncompensated risk”. I mostly own index funds, mostly vanguard index 500. I also own individual stocks and the risk is anything but “uncompensated”. For the last 15 years I have owned 3 individual stocks, Walmart, Apple, and Amazon. Although Walmart returns have lagged the index somewhat, AAPL and AMZN have absolutely trounced the index and are probably wort 15 to 20 times what I paid for them, with AAPL averaging 25 to 30% per year and AMZN averaging 35% per year. I believe I have been highly compensated for any risk that I took purchasing these stocks. Please explain your position.
It doesn’t really matter if you agree. It isn’t up for debate. It’s just the way it is. If a risk can be diversified away, why would you be paid for taking it? It doesn’t make sense.
Just because the risk didn’t show up in your case doesn’t mean it doesn’t exist.
That’s fine but I find it a iitle arrogant that you say it’s not up for debate. There is always room for debate on almost any investing proposition. I suppose your position is that I am similar to a lottery winner, which is certainly not the case. I suppose if you find any evidence to contradict your narrative i suppose you can ignore it and merely repeat the former narrative. I am certainly not the only one that has benefited from owning individual stocks. After all, all mutual funds are composed of individual stocks and the managers of these funds are mainly judged on very short term performance. If they can’t trade stocks with good short term performance, they are eliminated. If you are an individual investor you have the luxury of holding a stock as long as you wish. Index funds are a good alternative but so are individual stocks. I know you probably don’t believe this, don’t want to her this, and your mind was already made up a long time ago. I also know that, according to you, this is “settled Science”. Fortunately for me and many other people, we just don’t buy the narrative.
It’s not just a narrative. It’s very wide and deep evidence from the peer reviewed academic finance literature. You wouldn’t ignore the the academic medical literature in your medical practice. Why would you do that with investing?
I realize it sounds arrogant, but you’re basically arguing that the concept doesn’t exist. You’re arguing that a risk that is easily diversified away is somehow going to provide a premium. That’s not logical.
That doesn’t mean it isn’t impossible for someone to pick stocks well enough to beat the market, through skill and/or luck, even over the long term. But think about the alternatives here:
# 1 You got lucky. If this is the case, then the right move is not to do what you did, but to buy index funds.
# 2 You are skillful. If this is the case, you should be managing billions, not just your own portfolio. You could be adding value to the lives of thousands of people.
# 3 Any reasonably intelligent person can beat the market. This seems very unlikely given the evidence, and there is a plethora of evidence.
You’re arguing that the data showing #3 is flawed because the people we’re looking at (primarily mutual fund managers, where the data is most readily accessible) have different motivations than a long term investor. I think that’s a weak argument.
Enron.
Worldcom.
Kodak.
These are examples of individual company risk showing up. There are many more. The market might be fine. The industry might be fine. And yet the company does dramatically worse. Happens all the time.
I’m curious if you even track your returns. It feels more like cocktail party conversation where you only remember your winners. What are your annualized returns picking stocks over the last 20 years?
I rely on personal experience and I come from the school of hard knocks. I don’t put a lot of stock in peer reviewed studies regardng the stock market and market prognosticators. I certainly don’t listen to economic forecasts from many of the experts since weather forecasts are much more accurate. You can pick stocks after researching them yourself or you can rely on some money manager that has a turnover rate of 80 to 100% to pick them for you. This latter strategy is also termed “timing the market” and is the normal strategy in most mutual funds. I would assume that you know that none of these same “experts” that you are referring to also say that timing the market is not a great strategy. It is closer to day trading. This is a major reason that mutual funds can’t beat a simple index fund. I suppose you can allow one of these experts who run mutual funds and hedge funds to handle your money if you wish. However, they will be making many unnecessary and ill advised trades which eventually causes the manager’s demise, the fund’s demise, and your money’s demise. Even Warren Buffet tried to time airline stocks, lost money in a ponzi scheme, and BRKB has had an extremely poor record in the last 15 years. If I had listened to these “experts” over the last 15 yeas it would have cost me about 1.4 million. It’s hard to argue with personal experience as opposed to experts such as Dave Ramsey and James Cramer.
sten to economic forecasts since weather reports are much more accurate.
I agree you shouldn’t buy actively managed mutual funds. The evidence supports that assertion. It also supports the assertion that you shouldn’t try to run your own actively managed mutual fund. You can ignore it if you like. It’s your money and your consequences. But if you’re going to do it, at a minimum I would carefully track your returns, including all transaction costs and taxes and the value of your time. I bet if you honestly do that for 5 years you’ll quit picking stocks and just buy index funds. Or else you’ll go open a hedge fund. But either way, at least you would know if you are a skilled/lucky (either is fine) stock picker.
Actually I’m retired and I’ve been doing this for almost 50 years. Don’t mention hedge funds. They are a market timer’s nightmare. As I said you can put your money in an index fund, which is a reasonable choice. If you want to take slightly more risk for some opportunity for greater return, consider individual stocks and hold them for the long term. Do not trade actively and hold them. I have heard many “experts” say that you should buy actively managed funds so you can have an “expert” in your corner. This is absolute nonsense since actively managed funds almost never match the market due to short term time horizons, ridiculous over trading, and market timing techniques. As I have said, index funds are a good alternative to day trading active mutual funds and I fully support them, I do not believe that individual stocks should be dismissed just because many people do not know how to choose the right stocks. If you don’t feel comfortable choosing individual stocks then stick to index funds. Just don’t demean people that are successful at choosing individual stocks, especially when it’s obvious that they picked these individual stocks well.
So you haven’t kept track of your returns then? Neither you nor I know if you’ve really beat an index fund over the last 30-40 years, correct? So we don’t know if you have been successful at choosing individual stocks, do we?
I’m not sure why you say I have not kept track of my returns on individual stocks as opposed to the S&P 500. Actually, my returns for approximately 1975 to 2004 were fairly even with the S&P 500. That is when I started purchasing AAPL, AMZN, and Walmart . Amzn and AAPL have outperformed the S&P to such an extent that my total outperformance going back to 1975 is probably 3 to 4 %.. This is a significant amount of outperformance and is certainly not due to chance or luck or “winning the lottery”. I eo not believe in luck or chance.
Impressive. You reportedly beat the market by 3-4% over 40 years. You realize that makes you a better investor than Warren Buffett, right? How come you chose not to share your talents with the world?
It’s interesting that you would refer to Warren Buffet since he has had such a dismal record in the last 15 years. He had a stellar record before that . However, if you had invested in BRKB in the last 15 years I am sure that ypu wish you would have invested in the Vanguard Index 500. This would have been a good choice. Most of my holdings are in the Index 500. I also detect a hint of sarcasm in your reply ehich would indicate that I implied some secret strategy which I just made up. I must say that I don’t understand your position since I thought I stated my “secret” clearly. Allow me to repeat it. AAPL and AMZN. I realize that you may not believe it but these are individual stocks. My advice to your readers is to do your own research and think for yourself. Do not listen to self styled experts. These are the same people who sell newsletters online. The secret is that there is no secret. If you wish to do mutual funds, that is great. Index funds are the only way. However, if you want to do individual stocks do your research and invest for the long term. I mean at least 20 years. Do not trade. Invest and leave it there. There is no other way. That is my SECRET. I realize by your saracstic reply that you do not believe this is even though I just gave you 2 individual stocks that proven that this is the case. In conclusion I must say that the term “uncompensated risk” seems to come from someone who is trying to sell you something. I know I sound like a curmudgeon but I have found that over the years this is the only way to survive in this in esting jungle where everyone has a conflict of interest or trying to sell the latest fad.
So you did very well with those two stocks. More power to you. However, with investing it’s very difficult to tell the difference between luck and skill. You no doubt think it was skill, but almost certainly it was luck. Besides it doesn’t matter what happened in the past, it’s future returns that matter. For the best shot at the optimal outcome investors need a properly diversified portfolio, not a bet on a couple of stocks that might become super performers in the future.
of course there is luck involved in any investment whether it is individual stocks or mutual funds. I have said that the great majority of my holdings are index funds. I have 20 to 25% in individual stocks. There is no possible way that you can ferret out the luck part of stocks and the skill. Of course you can always claim that some guy that picked a particular stock was lucky. There is no possible way that you can establish that one way or another. However, you can follow certain guidelines, such as not “trading” and holding for the long term and you will tilt the odds in your favor. There have been many times even in the stocks that I have mentioned that dipped severely and I could have panicked and sold at a loss. So It’s not just being lucky. It’s also holding for the long term and not selling in a panic. This tilts the odds in your favor with any stock. You not only pick individual stocks but you also stay the course and do not sell when the chips are down. These strategies will increase your odds with any stock investment. Of course luck is involved with any investment but if you follow time honored buy and hold strategies you can tilt the odds in your favor. Obviously, these work and I have followed these principles for the last 45 years and have no regrets. I say again that 75% of my stock holdings are in the INDEX 500 and I follow the same principles with this fund as I do with individual stocks. There is no other way to do it successfully.
I wouldn’t describe 3-4% outperformance over 45 years as luck. Either you’re miscalculating returns or you are incredibly skillful. Beats me why you’re wasting time putting money in index funds with that kind of ability. Heck, beats me why you’re not managing billions.
There is definitely luck involved. You have to have some luck although the 2 stocks mentioned were responsible for most of the luck. I would never think about managing other people’s money. Hedge fund managers and mutual fund managers have a short term time horizon and, therefore, excessively trade and make ill advised trades in order to show how skillful they are. this strategy invariably backfires. All these managers are judged on short term performance and are akin to day traders. This strategy can never work in the long term nd is destined for under performance and failure. However, if you don’t follow the script and hold for the long term you are probably going to be fired anyway. Many mutual fund companies set up funds that have strategy of setting up funds that have exact opposite strategies. One fund goes long on some stocks and the other fund shorts the same stocks. One fund will do well and the other fund not so well. The fund company promotes the successful fund and eliminates the other. This kind of misleading strategy cannot work in the long run and is a good reason to put significant amount of your assets in index funds. You get a fair return on your assets without all the hype and nonsense. If you want to do some research and buy a few individual stocks and hold for the long term, that is a decent strategy. One thing not to do is get involved in actively managed mutual funds.
Isn’t that the point? Picking stocks you need some luck? With evidence based investing (using the empirical and theoretical data in the field, like we do in Medicine), you build a portfolio that will give you the most statistically reliable outcome. Surely a good thing for something as important as your financial security, rather than relying on luck?
It might be decent, but it is statistically unlikely to work out better than buying index funds. It worked out for you presumably, but you’re telling us it came down to just two stocks rather than any systematic ability to separate winning companies from losing ones. That’s not exactly confidence-inspiring.
To be fair there is luck involved in any strategy, even index bond funds. Anyone who says there is no luck involved in their strategy is most likely disingenuous. It’s is really not complicated. If you want a decent long term return all you have to do is buy Vanguard index 500 ans keep it forever. Good choice and you don’t have to be concerned about any evidence based investing. Throw in a couple of Index bond funds from vanguard and you are good to go. If you want to take a small portion and invest in an individual stock after careful research, go for it. Of course, I emphasize all this is long term and not day trading. After all, anyone can do it but few have the stomach for it.
Bottom line: individual stocks only present “uncompensated risk” if you choose the wrong stocks. I think we can all agree on that.
Uhhh…..I’m not sure you understand the concept. Although I will admit the concept relies on actually believing that one cannot reliably pick individual stocks that will beat the market. I guess if you don’t believe that, then I can see how the entire concept would make no sense to you. Good luck with your investments! Glad your stock picking habit seems to have worked out well for you, but like you, I don’t recommend it to people.
I think I need to add that I would not recommend considering individual stocks until you have built up a substantial portfolio of index funds so that the portion that you allow for individual stocks will not cause you to lose the milk money( in other words you can afford to lose). I admit there is more risk with individual stocks but there is more potential for reward if you can pick the right individual stocks. Just don’t bet the farm.
“there is more potential for reward if you can pick the right individual stocks.”
Hard to argue that point. But it’s also inconsistent for someone to say “buy index funds if you can pick the right individual stocks.” Either you can or you can’t. If you can’t, buy index funds. If you can, buy individual stocks.