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Last month we discussed asset allocation, which is the mix of investments suitable for your particular risk tolerance and which is the primary driver of investment returns. This month we’ll dive into some common questions about individual stocks and whether they should be included in a diversified portfolio.
 
What are stock returns?
 
There are three components of stock returns: cash paid out to you (dividends), growth in company profits (earnings), and changes in the market perception of a company’s worth (valuation). In the long run company profits account for the majority of stock returns, but in the short term the market’s perception of a stock’s fair price is highly variable and can have the biggest impact. Thus, analyzing a company’s profits or cash flow does not necessarily translate into high returns. This is one reason why picking individual stocks is so challenging.

What types of stocks generate higher returns?
 
According to Modern Portfolio Theory, higher risk leads to higher expected returns. Research suggests that there are three kinds of risk that explain almost all stock returns. First, the more volatile the stock relative to the whole market, the higher the returns (called market risk). Second,  smaller companies have higher risk and therefore higher expected returns (called small company risk). Third, and most interesting, is that financially distressed companies also have higher returns than more stable companies due to higher risk (called value risk). An implication from this research is that the return of your stock portfolio depends not on picking individual companies but rather the exposure of your stock portfolio to these risks.

How do you determine the correct price of a stock?
 
While there are numerous methods to determine the fair price of a stock, including estimating future cash flows and comparing a stock’s price to its profits, small changes in the assumptions can lead to large differences in the estimated fair price of a stock. Using the exact same data one financial analyst may state that a stock is underpriced while another says it’s overpriced. So if the fair price of a stock is a moving target, picking individual stocks which outperform also becomes a moving target.

How many stocks should you own?
 
Decades ago it was shown that having about 15 individual stocks, each in different industries, was sufficient to eliminate most of the risk inherent in one individual stock. Adding even more stocks reduced risk slightly but most of the risk reduction came from the addition of the first few stocks. More recent studies have shown that you need over 100 large company stocks for effective risk reduction and several hundred small company stocks to effectively reduce risk.

How likely is it for you to pick the winning stocks?
 
In an “efficient market”, all known information is incorporated into the price of a stock, meaning that the current price of a stock is the correct price. The price represents the collective wisdom of the entire market, including individuals, institutions, financial analysts, day traders and anyone else buying or selling the stock. As new information is received, the price of a stock changes, but the change in the price is random because new information is unpredictable. So, while it is possible to occasionally pick stocks which outperform the market, the chances of picking the winners consistently over the long term is extremely small. Think about it this way—you could study the balance sheet and other fundamentals of a company, but thousands of analysts have already researched this information. When you buy a stock, you think that the stock is underpriced, but someone else on the other side of the trade is selling and thinks that the stock is overpriced. It is through this constant tug-of-war mechanism that markets work and are efficient. Further, even if you identify a true anomaly in the market, if the rest of market does not recognize it, you may not realize the return. Several studies have shown that the overall return of an asset class is determined by just 10-25% of the stocks in that asset class—these particular stocks have spectacular returns, while the rest underperform the return of the asset class as a whole. In other words the chance that you will pick the next Microsoft is far less than the chance that you will pick the next GM or AIG.

Before you buy an individual stock ask yourself: what do I know that the market doesn’t already know? If you have truly inside information then perhaps individual stocks may be appropriate for a small portion of your portfolio, but as you can see, there is very little reason for most individual investors to own individual stocks. In upcoming months, I’ll discuss a better way to manage your portfolio via broad diversification beyond individual stocks.

Setu Mazumdar MD practices EM in Atlanta, GA and has passed the CFP® Certification Examination.
 

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