Allan Roth has written a wonderful book titled ‘How a Second Grader Beats Wall Street.’ Owning the market via indexing does the trick.
In the enclosed article dated June 16th 2010, “BP Teaches Three Key Investment Lessons,” Allan Roth highlights the risks associated with owning individual stocks!
He uses the example of British Petroleum (BP) one of the strongest companies on planet Earth...till the Gulf of Mexico disaster (in early 2010) that afflicted one of its offshore platforms causing major oil spill.
Some excerpts,
Let me first state the obvious by saying that owning any one stock is far more risky than owning the stock market as a whole.
BP started the year as one of the most valuable companies on the planet as measured by market capitalization.
Yet it was only one company.
Markets have stayed pretty flat so far this year, but a 50 percent decline in BP stock would equate to a 5 percent decline if your portfolio had ten stocks. Picking individual stocks increases risk without increasing expected return.
Further says Allan Roth,
Don’t confuse the unlikely with the impossible.
The collapse of such titans as Enron, Lehman Brothers, and General Motors, could never happen to BP, right?
BP, after all, has billions of barrels of proven oil reserves which is money in the bank.
My observations:
· Investors & stock pickers tend to believe in the invincibility, immortality and invincibility of their favourite companies...something like ‘this (i.e. misfortune) cannot happen to me!’
· Hence, Roth’s wise words don’t confuse the unlikely with the impossible.
· Stock prices in the future are moved by future events, news and information. News is inherently random and therefore unpredictable. What is publicly known (about a company) is more or less built into the market price...what is unknown is the knowledge that will move a stock (in the future) and this is impossible to forecast.
· Academic studies tell us that essentially all stocks have the same expected return as the market...the problem with individual stocks is they have this greater range of outcome which the academics call Standard Deviation.
· So, it makes little sense at all to buy an individual stock with this huge range of outcomes when you can have the same expected return at a narrower range of outcomes...via a broadly diversified index!
Link,
