The Dangers of Owning Individual Stocks
I don't mean to sound negative, but there are some very real risks associated with buying individual stocks.
Today's post is a two-part series looking at the dangers of owning individual stocks and what you can do to make sure that you are not exposing your portfolio to unnecessary and unrewarded risk. We will offer some helpful and prudent guidance regarding how to build a portfolio that ensures that you are diversified and how you can capture a stock market rate of return without the need to find the next hot stock or whether or not it is a good time to be invested in the stock market.
It is a truism that diversifying your portfolio is an important part of a well-rounded investment plan. Why? It reduces the risk of your overall investments going down in value since the risk is spread out among various holdings. Imagine if you only have one investment in your portfolio (or for that matter just a few stocks), that could be enough to cause you to lose money and expose your portfolio to undue and unnecessary risk. But if you have a broad market portfolio consisting of different types of investments and asset classes, then you are less likely to lose everything.
Today's post will cover a few things to think about regarding investing and the risk associated with individual stock investing.
First, we will focus on the financial media and how they romanticize companies and their leaders. These leaders take on a cult-like celebrity status where investors are enticed with FOMO (the fear of missing out) if they don't follow and invest with them and their company. Secondly, we will explore the importance of forming a sound investment philosophy. Once you determine your investment philosophy, you can then implement a strategy that aligns with that belief. Often, investors have never really thought about an investment philosophy but it determines how you should deploy your hard earned dollars prudently.
In part two next week we will discuss diversification and risk and define what it really means regarding our portfolio.
Let's get started.
The Financial Media and Why It Might be Helpful to Ignore the Hype
Here are some recent headlines from last week regarding what stocks to buy in the bear market:
In 1995, Newsweek columnist Jane Bryant Quinn wrote an article titled "The Big Tease." Quinn coined the phrase "financial porn" to describe the type of headlines that investors are subject to everyday in any of the market cycles that investors experience.
One cannot escape this type of investment porn since it is everywhere--tv, emails, website, even sms messages sent to your phone. There is a non-stop barrage of headlines that drive a narrative depending on the current market cycle. Since we are in the midst of a bear market and possible recession, naturally investors are fearful and seek the assurance that everything will be ok. These headlines are enticing since they promise investors they can buy these "hot stocks" and not be subject to the volatility and risk that all investors face when things are not good.
As an investor, when you see these headlines, it is good to take a step back with a deep breath and ask this simple question: how does the media make revenue? Of course, it is by advertising and making sure that their articles and headlines get a lot of "eyeballs" reading them. The more clicks, the more money they make and the higher they can charge advertisers. It is difficult to ignore but it is important to be aware of what is actually going on in the financial press so that you do not fall prey to these tactics. It would serve investors well if they can see it as entertainment and not prudent investment advice.
Beware of the Gurus - the Financial Media Gurus and the Cult Like CEOs
If you want to see how the media uses financial gurus to subject investors to financial porn, just flip on Jim Cramer's Mad Money for 10 minutes. He is the modern carnival barker as he shouts, paces, and preaches about the next hot stock, company, CEO and the like. He whips the audience in a frenzy in a style that would make PT Barnum happy.
Interestingly, academics at the Wharton School of the University of Pennsylvania took Cramer's Mad Money buy and sell picks and benchmarked them to the S&P 500.
"Under such a microscope, Cramer's stock picks lost luster. The Wharton researchers found that his AAP portfolio produced an annualized 4.08% return in the 17-plus years reviewed. At the same time, the S&P 500 gained 7.07%.
When applying an efficient frontier analysis — where raw returns are judged relative to how much market risk is being injected into a portfolio — the study's results raised even more red flags during this period. To be specific, Cramer's AAP portfolio generated annualized standard deviation of 17.65 and a Sharpe ratio of 0.16.
In finance, the Sharpe ratio measures the performance of an investment compared to a risk-free asset, after adjusting for its risk. Meanwhile, standard deviation is a statistical metric that can be used to quantify portfolio volatility against a market index.
The S&P 500 index in this timeframe had annualized standard deviation of 14.16 and a Sharpe Ratio of 0.41. Lower standard deviation translates into less exposure to market volatility while greater Sharpe numbers indicate better risk-reward characteristics. In other words, Cramer's AAP portfolio was not only providing its investors with significantly lower annualized returns, but also a bumpier ride in delivering such lagging performance."
There has been a constant debate among investment experts and economists regarding Elon Musk's Tesla and its valuation. One only has to follow TWITTER to see the hype and cult like status following regarding the electric car maker. If you look at the stock price of Tesla you will see a "boom-bust-boom trajectory" in which the hype becomes more important than the product and stock price.
As Bloomberg writer Austin Carr points out: "In many ways, his [Musk] success rides on going after goals that at first usually sound “completely delusional,” as he phrased it in 2017. It’s key to the Musk hype cycle, which we once summarized as follows: Start with wild promises, followed by product delays, production hell, shareholder anger, and finally, hopefully, redemption.”
As we will discuss later in part-two, there is a lot of risk associated with individual stocks that investors must consider since it exposes their portfolio to undue risk.
Cathie Wood and ARK Investment
Cathie Wood was the investment media darling with her ARK Innovation fund (ARKK) in 2020-2021. Many investors piled in as the media touted her as "the rockstar picker" that delivered "eye-popping returns."
Cathie made the bold prediction in May 2021 at a financial conference that her portfolios would triple over the next five years. This of course was made with the idea that her platform was innovative and due to something called a "escape velocity." (See Tweet below)
These types of bold predictions do not serve investors well since they are built on the idea that the guru has some sort of predictive power about the future and that all risk can be eliminated from investing since one can determine future stock performance. It is very dangerous to get caught up in the guru hype--whether it is a media personality or a company CEO or a "rockstar" fund manager. Take their predictions with a grain of salt. If they really knew what the market was going to do, why would they tell you?
The Critical Importance of an Investment Philosophy
Is the market efficient or inefficient?
It may sound silly that in order to have investment success you must determine an investment philosophy. You may have never thought about it before or pondered the question. However, an investment philosophy will dictate how you implement your portfolio strategy. In determining an investment philosophy, it comes down to two central questions--are markets efficient or inefficient?
A belief in an efficient market is simply that the current stock price of any company fully reflects all of the available information. Let's repeat that again--the prices FULLY reflect available information. The point is that it is impossible to find information about a stock that hasn't already affected the current price. Why is this important? Because if you are going to "beat the market" you do it by the means of the stock price. An efficient market belief posits that the market takes all of the available information and factors it into the current price.
On the flip side, a market inefficient belief would state that there is a way to find mispriced stocks and take advantage of that information in order to beat the market. The media gurus and stock pickers generally operate from this philosophy since it supports the idea that they know in advance what the market is going to do and whether or not they will beat it with their prediction.
As you will see later, a market inefficient approach can be very risky to investors and subject them to volatility.
Investors need to be aware of the fact that the media has a business model that relies on selling ads and getting readers. Therefore, the goal of the media is to create the highest volume of readers possible. This means that they must find stories that will attract attention. The non-stop barrage of headlines drives a narrative depending on the current market cycle. Investors can run the risk of becoming fearful and seek the assurance that everything will be ok.
To have investment success you must formulate an investment philosophy. You may have never thought about it before or pondered the question. However, an investment philosophy will dictate how you implement your portfolio strategy.
Over the next week, pay attention to the media headlines and see how they are designed to drive fear and uncertainty to its audience. Of course, if you have any questions or want to find out if your portfolio is exposed to unnecessary risk, please contact us.