Should You Own Individual Stocks?

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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.

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15 years ago

Do Barber and Odean take all individual stock pickers into account or do they limit there study to the top 20, 30, or 40%?

Should You Own Individual Stocks?

by Larry Swedroe time to read: 2 min
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