Investing in the stock market is highly recommended for those saving for a long-term goal. Historically, it’s been the most reliable way to build wealth. But the same is not true for investing in shares.
Stock markets move in cycles, with an upward bias over time. They fluctuate and fall over every few years, but usually recover and go on to set new highs. Not so with individual stocks. The majority eventually fail and disappear, undone by too much debt, poor profitability, by competition, innovation, changing technologies and fashions, or simply by mismanagement.
The financial media plays an important role in promoting sound investment habits, which it does, in the ‘personal finance’ sections. Here, investors are urged to use tax-advantaged retirement funds, invest according to their time horizon, keep costs low, use index funds rather than managed portfolios, to ride out market volatility and diversify adequately.
Elsewhere, though, the focus is on the daily gyrations of the stock market, sometimes with sensational headlines and forecasts that serve only to unnerve investors.
And then there is a perverse fixation on individual stocks. Be it on local or international television channels, magazines or newspapers we are never short of a view on which stocks to buy and sell. Retail publications offer analysis and coverage of SA’s top companies and investments – the guide to where your money should be.
But, the truth is, it shouldn’t be in individual stocks for a start, at least not your serious money. And most South Africans have only serious money.
There was a time when such reporting was understandable, when employees still received guaranteed pensions and the fund industry catering for discretionary savings was tiny. In 1980 there were just 12 unit trust funds; 10 years later, still only 36.
Those with money to spare opened a stockbroking account and managed their own portfolio. These were the dark ages. Stock prices were called out on the radio, or else you had to wait for the next day’s paper for the closing prices. Technical analysts would have to create their own charts, painstakingly updating them by hand every day.
Price-sensitive information was not fairly disseminated. There was no Stock Exchange News Service (Sens), no compulsory profit warnings. Trading updates were the privy of stockbrokers, or else shared among social and business networks. Those on the outside were disadvantaged.
The financial press played a valuable role then, tapping into this information flow, doing some company research and keeping retail investors in the loop as best as they could.
Today, there is no need for that anymore. We now have a massive asset management industry offering a choice of 2000+ unit trust funds that cater to every conceivable investment taste. No one has to buy their own shares anymore.
The problem with that is diversification, the ‘one free lunch for investors’ as it is described. It’s a ‘free lunch’ because it’s the only way to a higher return without taking on more risk.
Investors distinguish between two types of investment risk: market and stock-specific. The first affects the entire market, typically as a result of changes to the growth or interest rate outlook, a financial crisis or political developments. There’s no escaping this risk, other than to anticipate such events (although no one has ever done so consistently).
Stock-specific risk affects individual companies and industries, such as the current slump in construction spending. This can be neutralised by holding a variety of shares across different sectors and geographies, which perform differently at various stages in the business cycle. It’s also called diversifiable risk.
Based on numerous studies, holding a minimum of between 20 and 40 stocks in similar weights will eliminate most, but not all, stock-specific risk. To get the full benefit of diversification, you also need to ‘rebalance’ once in a while, by selling some of the winners, to buy more of the losers.
But if that’s what it takes, then you might as well just invest in a managed fund. Few people have the time or the skill to do this work properly, and to do it better than the professionals. Instead, they haphazardly hold a few stocks that strike their fancy.
That creates the opposite of diversification, namely concentration risk. That can work out in your favour if your small selection of stocks shoots the lights out. But it’s more likely that a rotten apple will spoil your return.
There have been plenty of those in recent years. Stocks like Steinhoff, Resilient, Tongaat Hulett, MTN, Brait and Massmart – all large and highly-regarded companies until recently – lost between 70% and 100% of their value, largely through their own fault. They are unlikely to recover in full any time soon.
Then there are stalwarts like Tiger Brands, which halved in value after being at the centre of a food-borne disease outbreak. Or British American Tobacco, the most defensive of businesses, which also dropped almost 50% after regulators proposed reducing the nicotine content and banning menthol cigarettes in the US.
These are just some of the more prominent recent collapses; there have been many others.
Holding any of these calamity stocks would have dented your capital in a big way, unless you were well-diversified. The performance of the FTSE/JSE All Share Index has been quite lack-lustre in recent years – partly because of these failures – but absorbed these body blows without a major correction.
But you don’t just come up against concentration risk when you hold just a few shares.
The pricing is against you. If diversification is your free lunch, concentration risk is your overpriced dinner. The markets value individual shares on the assumption that they are held within a diversified portfolio that neutralises stock-specific risk. If you own just a few shares, you have not eliminated this risk. Effectively, you are overpaying for these shares, for the risk you are taking.
The risk payoff profile is against you. A large, established business is more likely to spiral on a negative development than to soar on a positive one. Markets discount the potential upside – usually well-publicised by management – but cannot anticipate unexpected broadsides, such as MTN’s $3.2 billion Nigerian fine.
Price efficiency works against you. Markets are quite efficient at discounting the available information, so you really won’t get an edge studying historical data, be it through technical or fundamental analysis. Future price moves are random, which means that you really are just speculating, or following your own investment beliefs.
Your own behavioural biases also work against you. Of course, there is a chance that you invest in a stock that goes up ten-fold or more, as Naspers has. You can lose only 100% with a rotten apple, but your upside potential on winners is much higher. This so-called ‘positive skewness’ is attractive to those who see stocks as lottery tickets rather than investments.
But it’s well-established that people fear losses more than they value gains. This means you will be inclined to cash in your winners too soon and hold on to your losers too long, simply because you don’t want to confirm your loss, or give back some of your gains. To put it another way, you are more likely to ride Steinhoff all the way to the bottom than you are to ride Naspers all the way to the top.
Finally, you are unlikely to do better than average. Even when you do your own investing, you should still benchmark your performance. So how did you do relative to the overall market?
Earning the market return is simple, with a low-cost index fund. Beating the market return is hard, even for professional stock pickers. Over time, less than 20% manage to do so, after fees.
One reason is that outperformance tends to be concentrated in a few stocks or sectors over any period. If you aren’t in the winning space – which you may not be as a professional stock picker and you are unlikely to be with a concentrated portfolio – then you have virtually no chance of matching the market return.
The only way to do that is to own the entire market, with a broad, low-cost index fund. That should be the simple, sensible message drummed home to retail investors by the financial media. Punting individual stocks instead – implying that this is appropriate investment behaviour – is irresponsible and out of time.
Chris Eddy is the head of investments at 10X Investments.
The views and opinions shared in this article belong to their author, cannot be construed as financial advice, and do not necessarily mirror the views and opinions of Moneyweb.