Global Stock Markets have been or near all-time highs through out 2021. Every day we hear about "meme stocks" making headlines, and new investors are pouring into trading stocks on their cellphones.
The conditions make it easy to believe that the way to get wealthy with stocks is to pick a handful of winners, ride them to high prices, and then sell them for a profit. It has been interesting to talk to friends and family members who (at least I thought), had very little interest in investing and markets, all of a sudden are buying individual stocks on Robinhood.
On the one hand, I think its great that people want to invest. Historically, Canadian families have struggled to put away more of their income to save for their retirements. CIBC released the results of a poll in 2018 that showed that the average amount that Canadians save for retirement is only $184,000, while 30 per cent of respondents said they have no retirement savings and 19 per cent have saved less than $50,000. I think it will be great if one of the outcomes of the meme-stock frenzy is that people are now excited about saving and investing for the long term.
But, is investing in a small handful of individual stocks the right way to go about this? The data tells a different story. Historically Most investors have been much better of by simply investing in a broadly diversified set of stocks and/or bonds.
Dimensional Fund Advisors looked at the performance of a global market cap weighted basket of stocks from 1994 through the end of 2020. The total annualized return of that portfolio was 8.2% per year.
If you pick a small handful of stocks out of the 10,000+ stocks in a global index fund portfolio, you may get lucky and outperform for a short period of time. But, there's a good chance that you missed out on some of the big winners as well. What's the cost of missing out on the top performing stocks? Lets take a look.
If you missed out on the top 10% of performers each year, your annualized performance between 1994 and 2020 went from 8.2% per year down to 3.6% per year. Your return was more than cut in half.
If you missed out on the top 25% of performers each year, your annualized performance over the same period went from 8.2% per year down to -4.7% per year. You had a negative return, simply by missing out on the top quarter of global stocks over that timeframe.
Now, to be fair, if you're picking stocks you may not miss out on the top performers every single year. You may luck into a good pick from time to time. You may even get really lucky and outperform a simple index fund. The point of this discussion is to illustrate a few key ideas:
1) Beating the market is very hard, especially over long periods of time - you may get lucky in short bursts, but as the period of time lengthens, the chance that you will beat a systematic, low cost, broadly diversified approach become smaller and smaller
2) The individual stock investor takes on far more risk than the indexer - risk is a double edged sword. Of course, if you have a highly concentrated portfolio, you have the opportunity to dramatically outperform a simple index portfolio. You also have the exact same opportunity or likelihood to dramatically under-perform that simple index fund portfolio.
3) Indexing is incredibly boring, but also incredibly effective over long periods of time - nobody talks about how exciting it is to get benchmark returns less product fees when they're talking with their friends at the weekend barbeque. Indexing is boring. But, its also incredibly effective for the long run. So the question is - do you want excitement? Or, do you want reliable results for your retirement portfolio?
Chart Source: Dimensional Fund Advisors