The first investment I ever made was an individual stock. At that time, there were no apps or online accounts available to make this purchase. Instead, I walked into a local brokerage office, opened an account in person, sat across a desk from a stockbroker and asked him to place the trade. By the time I received the confirmation slip in the mail, roughly half of my money was gone.

What stays with me is not the loss. It is that nobody asked me anything. Nobody asked why I believed that company would do well, what would happen to my plans if I were wrong, or how much of my savings I was prepared to put behind a single idea. The order was placed, the confirmation arrived in the mail, and that was the whole of the advice. I am not certain I would have welcomed those questions at the time, since I was young and overconfident, but I have thought about them for more than thirty years and I have asked many people those same questions.

The reason they still matter is that the conversation itself has never changed. It is hard to get through a dinner or a business event without someone describing a stock they bought years ago that has gone up substantially, and what we rarely hear about is all the other stocks they bought that went nowhere. That is not because anyone is being dishonest. It is simply how memory works. We keep our winners close, we enjoy talking about them, and the disappointments quietly fall out of the story.

The stock name changes. The story never does.

There are good reasons to own stocks. Over long periods they have been one of the most effective ways to grow wealth and protect purchasing power from inflation. So the more interesting question is not whether to own stocks, but how to own them. Should you try to identify a handful of winning companies, or own a broadly diversified pool of them through mutual funds or ETFs? After more than three decades of watching Canadian families succeed and fail at this, my answer is direct: for almost every investor, there is no financial planning reason to own individual stocks. I am not saying you should never own an individual stock. I am saying the decision deserves a good reason. In my experience, most investors have never been asked to supply one.

Why is Picking Winning Individual Stocks so Difficult?

The challenge is not recognizing great companies after they have succeeded. It is identifying them beforehand, when their future is still uncertain and their share price already reflects everything millions of other investors know and expect.

Research by Arizona State University professor Hendrik Bessembinder shows just how difficult that is. In Do Stocks Outperform Treasury Bills? published in the Journal of Financial Economics, he examined the lifetime returns of every U.S. common stock since 1926 and found that the best-performing 4 per cent of listed companies accounted for the entire net wealth creation of the U.S. market above one-month Treasury bills. Slightly more than four out of every seven individual stocks did not even match the return of a Treasury bill over their lifetimes. That deserves a second read, because it means most individual stocks are not merely disappointing. Most individual stocks did worse than holding cash. Nor is this only an American phenomenon. Bessembinder and his co-authors extended the work to more than 64,000 companies worldwide and found the same pattern outside the United States.

The point is not that the stock market is a bad place to be. Over the long run it has rewarded investors generously. The point is that the reward has been concentrated in remarkably few places, which changes what you are actually attempting when you buy a handful of companies. You are not making a modest bet with slightly unfavourable odds. You are trying to locate a very small number of names inside a very large field, in advance, with a share price that already reflects everyone else’s best guess. Bessembinder tested exactly that by simulating single-stock selection repeatedly, and the single-stock strategy underperformed the broad market in 96 per cent of those simulations.

So why does anyone keep doing it? Because nothing ever tells them to stop.

You do not have to lose money for stock picking to fail. You only have to earn less than you would have earned by owning the broad market. An investor can make money every single year, comfortably ahead of any fixed-income alternative, and still be quietly falling behind the entire time. The statements look fine. There is no line item for the return you did not earn, no alert when the gap widens, and nothing that ever prompts a review. It is the most expensive kind of loss precisely because it never announces itself.

A broadly diversified portfolio removes the guessing. You will own plenty of disappointing companies along the way, but you will also own the small number of extraordinary ones, because you own all of them.

If an Individual Stock I bought went up, does that mean it was a Good Decision?

Not on its own, and this is where the first article in this series does the most work. There I made the case that a good decision can produce a bad outcome and a bad decision can produce a good one, and I offered a test for telling skill from luck: could you lose on purpose? In a game of skill you can deliberately play badly and reliably lose. In a game of chance you cannot.

Apply that test to stock picking. If you set out tomorrow to deliberately choose the worst-performing stocks in the market, could you reliably do it? Almost nobody can, and that tells you a great deal about how much skill is actually available in the activity. The answer is the same whether your last pick went up or down. So if you put a significant portion of your portfolio into one company and watched it appreciate, you may well have seen something other investors missed, or you may equally have taken a risk you did not need to take and been lucky enough to have it work out. The return by itself cannot tell you which one happened.

This matters because success changes behaviour. A winning stock reinforces our belief that we have some ability to spot winners, and once we believe that, there is no reason to change what appears to be working. I have watched that sequence more times than I can count, and it almost always runs in the same direction. The winner is rarely the last decision. It is the decision that funds the next, bigger one.

Am I taking a Risk I do not need to take?

Concentrating wealth in a few companies introduces company-specific risk, which we call uncompensated risk in investment jargon. In plain English, it is a risk that can largely be diversified away, so there is no reliable reason to expect a higher return simply for bearing it.

Concentrated portfolios can certainly outperform diversified ones, sometimes by a great deal, and that has never been in dispute. The question I would ask is a different one: do you need to take that chance to get where you are going? If a diversified portfolio already gives you a reasonable probability of accomplishing your goals, then any additional risk that could jeopardize them should clear a very high bar. In my experience, very few of them do.

Is a Canadian Portfolio as Diversified as it looks?

There is a second concentration problem that most Canadian investors never notice, and it sits underneath the first one. The Canadian market is not a balanced market. It is dominated by financial services, meaning the large banks and insurers, and by resources. Rocks and trees, as it is often described. Entire sectors that make up a large share of global markets, including technology, health care and consumer businesses, are only lightly represented here. So a portfolio invested entirely in a Canadian index is already a concentrated bet, even though it holds hundreds of companies and carries the word diversified on the label. Continue Reading…