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!
not really. Buy index funds until you build up substantial holdings. Leave those holdings in place. At this point you can consider individual stocks. If you are not comfortable going this route you will still be fine with index funds. You will receive a fair return. If you want to branch out into individual stocks and do your research go for it. Just don’t bet the farm on single stocks. On the other hand I think an individual investor can do better on individual stocks than the so called experts from hedge funds and mutual funds. They have already proved that their “day trading” never works. You are not hamstrung to their 100% turnover records that they repeat year after year. Since many people, including WCI, believe that you can’t compete with these venerable “experts”, I would suggest that anyone who feels this way should check the turnover ratio of these same mutual funds and hedge funds that these so called experts manage. This is called market timing where i come from and i happen to know that WCI does not support market timing. But I could be wrong about this. Anyone from WCI can correct me if they actually do believe in market timing since this is exactly what these mutual fund managers and hedge fund managers do every day.
Why would you invest in an evidence based manner (best shot at the optimal outcome) until you build up substantial holdings, then branch out to a less than optimal strategy?
As you’ve been investing around 45 years, when you started there was no evidenced based investing. There was no choice but to pick individual stocks. But now there is a choice. Especially for new investors starting out, learning about different strategies, it just makes sense to me to follow the evidence, rather than relying on luck that you pick a few super performers.
No. I neither support market timing nor using actively managed mutual funds. I also agree that lowering turnover likely improves the likelihood of outperformance. But, while necessary, I don’t think low turnover is a sufficient condition for success.
just because you think that index funds are the way to go in most cases(and I do) doesn’t mean you can’t use a little “mad money” and buy a few individual stocks, especially if you do your research and you won’t need that money to keep a roof over your head or food on the table.
Is that really the most fun thing you can think of to do with your money? I find that particular argument weak. I’d rather use my mad money to buy a raft and go white water rafting than underperform the market despite pouring a ton of time and effort into it.
Just because you can pick stocks does not mean you shouldn’t use index funds. Picking funds is higher risk and should only be used with money that yoiu can afford to lose part of your investment, which is same as mutual funds. However, individual stocks have more probability ofusing the entire investment. However, if you are already invested in index funds, then i see no harm in doing research and place smallportion of your portfolio into individual.You have a chance to make significant gains if you can pick the right stocks.
Why is it higher risk to pick stocks if you have the ability to pick them well enough to beat the market? If you have that ability, your risk should be lower and your returns should be higher.
I think deep down you suspect you may not actually have that ability and that you just got lucky though. That’s why it feels risky. I know I don’t have that ability. So I think the best strategy for me is to not play that game at all.
Actually, I said to use a small portion of your portfolio to consider buying individual stocks if losing that money will cause you no financial problems. If losing this money will cause major problems, keep it all in index funds. If all my individual stocks became worthless tomorrow, it would not affect my lifestyle one iota. It just happens that I am able to contribute to my favorite charities and have no particular worries in that regard. The only effect it would have on me is that I would have less money to donate. If you need that money to live you may want to try a different strategy.
You’re going back and forth now. This argument you’re using would apply to whole life insurance, cryptocurrency, or putting it all on red in Vegas. I agree that if you don’t need the money or it’s money you can lose that you can throw it away anyway you like. But that’s very different from saying “it is a good idea to try to beat the market by picking individual stocks” whether it is done with a small portion or a large portion of the portfolio. That was your original argument. If you want to stick to that argument, then logic dictates this:
If you’re good at it, you should do it with a large part of the portfolio. If you’re not good at it you shouldn’t do it at all.
But there’s no logical reason to do it with a small percentage of the portfolio, even if you can afford to do it. Are you now backing away from your prior argument that you can beat the market reliably and others can too? Because if so, I think we’re done here.
That’s all fine and good. I suppose I’m lucky in my foray into individual stocks. That’s all fine and good.Ii believe it . I am lucky for beating the S&P 500 for 45 years. I confess that I am severely lucky. That could be the only explanation. It’s kind of like the guy that won the lottery or aa guy that ran a ponzi scheme for 20 years. Actually, when you think about it, I’ve been more lucky than Bernie Madoff since he only ran his scheme for 20 to 25 years. I admit I could be the second luckiest guy in the world(after Bernie Madoff). I admit that it was 100% luck. On the other hand, this “luck” has lasted 45 years so I’ll take it where i can get it.I have learned over the years that many of the so called “experts” have always claimed “luck” when confronted with conflicting information. That’s fine. I can handle that. I believe that you are sincere in your beliefs. However, do you ever consider that individual investors are, indeed, capable of buying individual stocks that might turn out to actually outperform the indexes. That is a possibility since I have been doing it for 45 years and most of the gains have been due to AAPL and AMZN. These 2 stocks have absolutely crushed the indexes for the last 15 years. Any investor could have done the same thing. On the other hand you seem to claim it is all luck and impossible. That’s interesting but I have been LUCKY for the last 45 years. i admit that I must be the luckiest guy in the world. However, my father invested back in the 50’s 60’s and 70’s and he invested in individual stocks. He did extremely well and I watched his techniques for due diligence. He was extremely successful. I realize I am the luckiest investor in the world because there could be no other explanation for anyone who could outperform any of the so called experts who run mutual funds and hedge funds. I will admit that I am the luckiest investor in the world, even luckier than Bernie Madoff.
Uhhh….okay. I think we’re done here.
Congratulations on your success and good luck investing.
One last comment on the propriety of investing in individual stocks. You stated that if someone thinks he can possibly outperform with individual stocks, then why not put all your assets in individual stocks and nothing in stock market index funds? I don’t quite understand this reasoning. FolIowing your line of reasoning I might ask that if you can outperform with stock index funds, why not put all your assets in stock index funds and zero in bond index funds. After all, you can certainly do better with the stock index funds. I would assume it is because you want something with less volatility than a stock index fund. It is volatile in the short run but pays off in the long run. Individual stocks are more volatile than stock index funds in the short term but have greater potential for gain in the long term. If you do not want to tolerate this kind of volatility then you should simply invest in index funds. If you can tolerate volatility then you might add something different to the mix. After all, anyone can do it but FEW HAVE THE STOMACH FOR IT.
I disagree that anyone can do it. In fact, I think very few can do it.
Good luck investing.
I intended that that would be my last post on the subject. However, it appeared that you ignored my point regarding the question of whether you should just put all your money in stock index funds as opposed to bond inde funds. Since your point earlier ws that I should put a;ll my funds in individual stocks since I claim i cn do better that way, then you should place all your funds in stock index funds since you claim that this strategy has a better return. I realize that all the “experts” say that there is no way it can be done but in many cases they are telling you to invest in their hedge fund or mutual fund t the same time. Anyway, my point is that you didn’t address the fact that someone might want securities of different volatility in their portfolios. If you don’t think it can be done, fine. I guess we’ll have to agree to disagree. On the other hand , the proof is in the pudding.
I do place all of my stock money into stock index funds.
The only “proof” we’ve seen is your claims to have beaten the market by purchasing Amazon and Apple at very good prides.
I agree that you don’t seem likely to be convinced of the follies of taking on the uncompensated risk of individual stock investing given your experience with those two stocks. But every time I log back in there is another comment or three from you asking me to respond. Would you feel better to have the last word on the subject? I can certainly let you have that.
I respect your position and I certainly believe that it is a very good and reasonable position. I think anyone following your position will be fine. I think your website is a very useful tool for investors and I thank you for the opportunity to me to express a slightly nuanced view of the investing landscape. We agree on about 90% of the issues so I just want to thank you again for listening to a slightly different view on a few things. Thanks again.
I hate to make another comment on this subject but I just couldn’t resist. I just came across some interesting figures regarding index funds and the 2 individual stocks mentioned, AMZN and AAPL. WCI dismisses individual stocks in favor of all stock index funds. That is interesting in light of the fact that AAPL and AMZN make up 10 % of the Vanguard Index 500. They make up close to 20% of the Vanguard Growth Index Fund. This means that anyone who owns these 2 index funds has an overweighted position in these 2 stocks, possibly without even knowing it. My position in these 2 stocks is in line with these 2 funds. The index 500 is one of the most widely held funds in the world and the Growth fund is very popular also. It appears that your index funds could be subject to uncompensated risk.
I don’t think you understand the meaning of the word “overweighted”.
10% is market weight. If you own more of it than that, you are overweighted. If you own less, you are underweighted. The market capitalization sets the standard for what over and under weighting is.
Isn’t it fun that an index investor owns all of the winners without even trying? No special foreknowledge or effort required and yet I bought Apple and Amazon on the day I started investing all those years ago and got to enjoy the ride.
Overweighted is a very interesting concept. It seems that anyone who invests in Vanguard Growth is :overweighted” in AAPL and AMZN simply because these 2 stocks have outperformed the market to an unprecedented extent. Same thing with the S&P 500. I must admit that I, being a redneck, fail to see the difference between someone owning a mutual fund that has an “overweight” position in AAPl and AMZN of as much as 20 percent or more and someone who owns, as part of his portfolio, a 20 percent stake in the same stocks. If you own these stocks individually or as part of a mutual fund, what difference does it make? BTW, most “financial professionals” would advise most investors not to have a portfolio that consists of 100% stocks, whether index funds or individual stocks. According to “experts”, this would be very risky. I don’t necessarily say it is overly risky, but most experts say it is risky. The only great expert I am aware of that recommends this approach is the greatest “expert” of them all, THE GREAT DAVE RAMSEY, who everyone knows is a man who has no peers.
Overweighting is a very straight forward concept. If a given stock is X% in a given market, and you own more than X% of the stock, by owning the stock directly, in a mutual fund, or anything else, you are overweighting that stock. It is no more complicated than that.
It is kind of silly to talk about advanced concepts such as uncompensated risk and overweighting until one accepts that picking stocks is a fool’s errand. Since you haven’t accepted that, it should not be surprising that the more advanced concepts that rely on that premise to make sense don’t make sense to you.
But yes, a growth fund overweights growth stocks compared to the overall market.
yes, it appears that uncompensated risk is a part og MODERN PORTFOLIO THEORY. They use statistics that include 3000 to 4000 existing stocks. that is an interesting concept since I would not even consider 98 percent of these stocks in the first place. I would agree with thia concept if you include almost all stocks in existence or the top 4000 stocks in existence. If you eliminate 98% of them and only include Blue chips in the S&P 500 and then narrow it down to the very best o these stocks, then you increase the probabilities of success. For instance, if I decided 15 years ago that FAANG stocks and Microsoft would be good to consider (which I did), then I would decide which ones of these stocks I might buy. Anyone who purchsed any of these stocks at any point in the last 15 years has been rewarded many times over. I suppose that it was a good thing that I didn’t know anything about uncompensated risk 20 years ago.
There are many stocks that were “blue chips” 15-40 years ago that no longer are. Take a look at this:
https://www.youtube.com/watch?v=fobx4wIS6W0
I thought we “agreed to disagree” but a couple of times a week you come back to leave another comment here about this. Is that because you are losing confidence in your ability to pick winning stocks moving forward?
These large cap stocks you are referring to do not turn on a dime. You have plenty of time to adjust your holdings. FAANG and MICROSOFT beg to disagree. As I said, ANYONE who invested in ANY of these stocks at ANY point in the last 15 years enjoyed a return of 26 to 40 percent a year. This means that you would have a massive 26 to 40 percent return in the last 15 years. Also, it didn’t matter when, in the last 15 years you bought ANY of these stocks. You still would have made massive gains. Warren Buffet used to be able to pick stocks but he avoided these stocks until he bought AAPL 2 years ago. Now AAPL is 20 percent of BRKB. Unfortunately, it has not been enough to save BRKB from mediocrity. Betting on Warren Buffet is like betting on Tiger Woods. It’s about 10 to 15 years too late.
Congratulations on your success. See you tomorrow with your next comment.
Here is my next daily comment. I will dispense with opinions and present data. If I am not mistaken, you have recommended to your readers that they maintain a significant amount of their portfolio in International Index funds (as much as 25%). Correct me if I am wrong but I believe you have recommended Vanguard for this. I love Vanguard too but let’s analyze this fir a minute. If you had invested $10000 in the Vanguard International Stock Index Fund 10 years ago you would have about 14 to 15 thousand dollars in your account. NOT GREAT. If you had invested in the Index 500 you would have approximately 36000. GOOD. If you had invested in WALMART you would have 26000 (not great but better than the Foreign Fund. If you had bought AAPL you would have approximately 100000. Interesting. If you had invested in AMZN you would have close to 150000. Although WMT lagged the S&P 500 it still trashed the Foreign Index Fund. The other stocks completely trashed both indexes but the Foreign stock was completely destroyed all the way around. And, yet, you recommended foreign stock index funds. Where is the real UNCOMPENSATED RISK? If what I am doing is UNCOMPENSATED RISK I can’t wait to be compensated.
I’m amazed at your ability to mine retrospective data. If you’re going to pick stocks retroactively, why not pick the best ones Biff? Just whip out your almanac.
https://www.youtube.com/watch?v=zorz3SXqjv0
At this point, I’m just assuming you’re trolling me so I’m going to treat you like I do all trolls on this site. Goodbye.
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