Should You Own Individual Stocks?

By Larry Swedroe, on March 6, 2009

In this Ask The Expert With Larry Swedroe article, Glblguy from Gather Little By Little asked Larry how he can identify the best individual stocks to invest in. Here’s the question from Glblguy:

When deciding to purchase individual stocks, what process do you go through to determine if the stock is a good buy or not?

Answer From Larry Swedroe

One of my rules of prudent investing is that no one should own individual stocks. That has far more to do with speculating than investing. Instead own only mutual funds (or ETFs) that own all the stocks within a particular asset class (e.g., small caps, value stocks, emerging market stocks, etc.). Then build a globally diversified portfolio of a number of these funds-one that reflects your unique ability, willingness and need to take risk. My latest book Wise Investing Made Simple, provides a list of the recommend investments and also a model portfolio you can use. By the way, I don’t own any individual stocks and have not for a very long time.

Individuals Investors Versus Institutional Investors

There is a wonderful series of studies on the results of stock trading by individuals by Professors Brad Barber and Terrance Odean. One of their studies found that the stocks individuals buy underperform after they buy them and outperform after they sell them. This is actually a commonsense outcome. The reason is relatively simple. Let me explain. For every buyer there must be a seller. Since the vast majority (about 80%) of the trading is done by institutional investors (who almost certainly know more than the individual investor) that it is likely that when an individual buys a stocks (because he thinks it will outperform the market) the likely seller is an institution (who thinks it will underperform or they would continue to hold it). And the institutional investor is more likely to be right.

And the same is true when the individual sells (because he thinks the stock will underperform) and the buyer is likely to be an institutional investor (who thinks it will outperform). Again, only one can be right and it is likely to be the institution. A study by Russ Wermers found that the stocks institutional investors (mutual funds) buy actually do outperform by about 70 basis points. Thus they are exploiting the individual investors lack of knowledge.

Taking this one step further, when an institutional investor trades the likely counterparty is another institution in most cases (about 80%). And only one of them can be right. It turns out that the evidence demonstrates that there are just not enough victims to exploits. The study by Wermers found that while the stocks the mutual funds bought did beat the market by about 70bp the funds underperformed proper benchmarks by about 1.6% per annum because they incurred an average of 2.3% in total costs (not just the fund’s operating expense ratio but all trading costs and the cost of sitting with cash). In other words, there were just not enough victims (individual investors like you) to exploit to overcome the burden of expenses.

You can find the studies by Barber and Odean on the Internet. Rational Investing in Irrational Times also discusses several of their studies.

Disclaimer

• Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
• Not all questions will be answered
• By submitting a question, you grant us the right to publish your question.
• The answer is given based on the information provided in your question. Please seek professional assistance for more personalized advice.

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Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri. He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services. Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You'll Ever Need (updated and re-released in 2005), as well as six other books. Most recently, he authored The Only Guide to Alternative Investments You'll Ever Need (2008). Larry has started his own blog called Wise Investing at CBS Money Watch. Please check it out!

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