DIY diagnosis: the unhealthy risks of self-managed share portfolios
Article written by Anthony Edmonds, InvestNow – 30th June 2022
InvestNow Founder and Managing Director, Anthony Edmonds, explains why do-it-yourself share-trading portfolios could be harmful to the long-term wealth of Kiwis…
Holed up at home during a wet Wellington weekend with a decent dose of COVID, I managed to squeeze in an unhealthy amount of reading.
Among the stack of digital literature piling up on my laptop included two online articles directly at odds with each other.
In ‘What should you look for in a stock’, the head of wealth for one of NZ’s largest share-advisory networks provided a few pointers to investors on what factors to consider when buying equities.
Typical of its genre, the article implied stock-selection is a simple process that anyone can master after absorbing a few bullet points of expert wisdom.
And in one sense the story was bang on: buying equities has never been easier than in this era of low-cost (or even free) online share-trading platforms that encourage wanna-be investors to ‘shoot for the moon’ as DIY portfolio managers.
But while anyone can now dabble in share-trading on seemingly the same terms as professionals, an analysis published by US-based investor, Larry Swedroe, in 2021 should give them pause before clicking on the buy-button and triggering a shower of digital confetti.
Swedroe concludes in his well-researched ‘The risks in buying individual stocks’ article that most individual investors simply can’t achieve the level of diversification necessary to manage share portfolio volatility.
Based on research by Burton Malkiel, John Campbell, Yexiao Xu and Martin Lettau, in their paper titled ‘Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk’, he says an adequately diversified global shares portfolio today would need to hold at least several hundred securities to manage the risks associated with owning equities.
Citing historical data, Swedroe shows that the average volatility of individual stocks has increased significantly over the last few decades – implying it has become even more risky to own just a handful of companies in share portfolios. Interestingly, the average total market volatility has remained more-or-less stable during the same period, which adds further weight to the diversification argument.
Even over the bumper year for the US S&P 500 in 2020 more than 200 stocks – or about 40% – lost money while 10 shares fell by close to half (or more).
Coming out of the global financial crisis in 2009, the same index returned 26.5%, Swedroe says, but 40% of the total 7,608 companies listed in the US at the time were in the red for the year.
“Yet, only 0.4 percent of domestic equity mutual funds lost value,” he says.
Similarly, a 2021 study by giant US investment manager, Dimensional Fund Advisors (DFA), found over 20-year periods dating back to 1927 almost one-in-five companies suffered a “bad delist” leaving investors out-of-pocket.
The DFA report also shows single shares experienced a wide range of returns during the periods under analysis with little correlation between past and future performance.
“Only about a fifth of stocks survive and outperform the market over 20-year periods,” the study says.
Why staying single is a sickness
Despite the weight of history suggesting share-trading is mainly a losing game for amateur players, investors continue to pile into poorly diversified stock portfolios for various reasons, according to the DFA report.
“Many investors end up holding large concentrated positions in single stocks, whether as the result of employee compensation or a handsomely rewarded stock selection. Familiarity with these stocks or a successful track record while holding them may discourage investors from diversifying,” the DFA paper says. “Unfortunately, this can lead to one of the most well-known cautionary tales in finance: tragic declines in wealth from losses in single securities.”
Likewise, Swedroe offers a list of explanations for why DIY portfolios tend to hold only a few stocks skewed to certain sectors, namely such investors:
- have an irrational self-belief in their ability to pick stocks that will outperform the market;
- conflate ‘familiar’ with ‘safe’ – investing more in companies they have heard of while excluding lesser-known stocks;
- don’t have the academic or practical knowledge of how to build a properly diversified portfolio; and,
- can’t distinguish between ‘good risks’ – such as the higher long-term expected returns of shares compared to bonds – and ‘bad risks’ associated with owning an individual company stock
“Individual stock ownership provides both the hope of great returns (finding the next Tesla) and the potential for disastrous results (ending up with the next Enron). Since investors are not compensated for taking the risk that a result will be disastrous (just ask investors in once great companies, such as Lehman Brothers, Fannie Mae, Eastman Kodak and Polaroid, to name just a few), the rational strategy is not to play,” Swedroe says. “Unfortunately, the evidence is that the average investor, while being risk averse, doesn’t act that way—in a triumph of hope over wisdom and experience, they fail to diversify.”
In short, he says holding just a few shares (especially if it represents the majority of an individual’s assets) is more akin to speculation than investment.
Diversification, democratisation and the cure for speculation
The points raised by Swedroe et al provide a useful antidote to the messages flooding all marketing channels that promote stock-trading as a fun-and-easy pastime for the average Kiwi.
Direct share-trading platforms are lightly regulated in NZ, giving the providers little incentive to spell-out the well-known risks of owning a concentrated basket of shares or the practical difficulties of building a truly diversified portfolio.
Furthermore, investors in NZ need to consider the other consequences of direct share-trading versus holding managed funds – notably the tax benefits of using portfolio investment entity (PIE) structures and the tax risks associated with individual ownership of NZ and Australian shares.
While the subject is frequently glossed over, DIY investors in Australian and NZ equities can be deemed as traders by the Inland Revenue Department, potentially triggering capital gains tax liabilities.
What does a well-diversified global equities portfolio actually look like? A sample of a few of the international share funds on InvestNow offers a good guide:
- the Macquarie All Country Global Shares Index Fund invests in more than 1,500 individual shares;
- ANZ Investments OneAnswer International Share Fund holds over 350 stocks; and,
- the Harbour T. Rowe Price Global Equity Fund has a more concentrated portfolio of just over 230 individual shares – and has a higher volatility than the previous two funds to show for it.
Of course, many funds – including some available on InvestNow – might comprise only 30 or 40 underlying securities but investors typically use these concentrated portfolios as part of a broader strategy rather than the main event.
Holding a more-concentrated basket of shares will inevitably lead to greater volatility without necessarily delivering long-term returns above, or even equal to, a broadly diversified portfolio.
Given most individuals will never be able to directly own, or manage, a decently diversified equities portfolio of even the size of say, the Harbour T. Rowe Price Global Equity Fund, the share-trading platform promise of ‘democratising’ investment should be taken with caution.
‘Democratisation’ of share-trading may make for a winning catch-phrase but as a famous quote attributed to Warren Buffet puts it: “In the short-run, the stock market is a voting machine. Yet, in the long-run, it is a weighing machine.”
Light-weight regulation of the sector enables platforms to heavily promote self-managing shares as a harmless hobby without warning punters that it also comes with a significant risk of long-term wealth-loss.
Kiwi investors should apply some scepticism before piling their life-savings into a self-managed share portfolio with paid-to-trade platforms or brokers, selling impossible dreams and real dangers you would not read about in the brochure.
DIY diagnosis: the unhealthy risks of self-managed share portfolios
Article written by Anthony Edmonds, InvestNow – 30th June 2022
InvestNow Founder and Managing Director, Anthony Edmonds, explains why do-it-yourself share-trading portfolios could be harmful to the long-term wealth of Kiwis…
Holed up at home during a wet Wellington weekend with a decent dose of COVID, I managed to squeeze in an unhealthy amount of reading.
Among the stack of digital literature piling up on my laptop included two online articles directly at odds with each other.
In ‘What should you look for in a stock’, the head of wealth for one of NZ’s largest share-advisory networks provided a few pointers to investors on what factors to consider when buying equities.
Typical of its genre, the article implied stock-selection is a simple process that anyone can master after absorbing a few bullet points of expert wisdom.
And in one sense the story was bang on: buying equities has never been easier than in this era of low-cost (or even free) online share-trading platforms that encourage wanna-be investors to ‘shoot for the moon’ as DIY portfolio managers.
But while anyone can now dabble in share-trading on seemingly the same terms as professionals, an analysis published by US-based investor, Larry Swedroe, in 2021 should give them pause before clicking on the buy-button and triggering a shower of digital confetti.
Swedroe concludes in his well-researched ‘The risks in buying individual stocks’ article that most individual investors simply can’t achieve the level of diversification necessary to manage share portfolio volatility.
Based on research by Burton Malkiel, John Campbell, Yexiao Xu and Martin Lettau, in their paper titled ‘Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk’, he says an adequately diversified global shares portfolio today would need to hold at least several hundred securities to manage the risks associated with owning equities.
Citing historical data, Swedroe shows that the average volatility of individual stocks has increased significantly over the last few decades – implying it has become even more risky to own just a handful of companies in share portfolios. Interestingly, the average total market volatility has remained more-or-less stable during the same period, which adds further weight to the diversification argument.
Even over the bumper year for the US S&P 500 in 2020 more than 200 stocks – or about 40% – lost money while 10 shares fell by close to half (or more).
Coming out of the global financial crisis in 2009, the same index returned 26.5%, Swedroe says, but 40% of the total 7,608 companies listed in the US at the time were in the red for the year.
“Yet, only 0.4 percent of domestic equity mutual funds lost value,” he says.
Similarly, a 2021 study by giant US investment manager, Dimensional Fund Advisors (DFA), found over 20-year periods dating back to 1927 almost one-in-five companies suffered a “bad delist” leaving investors out-of-pocket.
The DFA report also shows single shares experienced a wide range of returns during the periods under analysis with little correlation between past and future performance.
“Only about a fifth of stocks survive and outperform the market over 20-year periods,” the study says.
Why staying single is a sickness
Despite the weight of history suggesting share-trading is mainly a losing game for amateur players, investors continue to pile into poorly diversified stock portfolios for various reasons, according to the DFA report.
“Many investors end up holding large concentrated positions in single stocks, whether as the result of employee compensation or a handsomely rewarded stock selection. Familiarity with these stocks or a successful track record while holding them may discourage investors from diversifying,” the DFA paper says. “Unfortunately, this can lead to one of the most well-known cautionary tales in finance: tragic declines in wealth from losses in single securities.”
Likewise, Swedroe offers a list of explanations for why DIY portfolios tend to hold only a few stocks skewed to certain sectors, namely such investors:
- have an irrational self-belief in their ability to pick stocks that will outperform the market;
- conflate ‘familiar’ with ‘safe’ – investing more in companies they have heard of while excluding lesser-known stocks;
- don’t have the academic or practical knowledge of how to build a properly diversified portfolio; and,
- can’t distinguish between ‘good risks’ – such as the higher long-term expected returns of shares compared to bonds – and ‘bad risks’ associated with owning an individual company stock
“Individual stock ownership provides both the hope of great returns (finding the next Tesla) and the potential for disastrous results (ending up with the next Enron). Since investors are not compensated for taking the risk that a result will be disastrous (just ask investors in once great companies, such as Lehman Brothers, Fannie Mae, Eastman Kodak and Polaroid, to name just a few), the rational strategy is not to play,” Swedroe says. “Unfortunately, the evidence is that the average investor, while being risk averse, doesn’t act that way—in a triumph of hope over wisdom and experience, they fail to diversify.”
In short, he says holding just a few shares (especially if it represents the majority of an individual’s assets) is more akin to speculation than investment.
Diversification, democratisation and the cure for speculation
The points raised by Swedroe et al provide a useful antidote to the messages flooding all marketing channels that promote stock-trading as a fun-and-easy pastime for the average Kiwi.
Direct share-trading platforms are lightly regulated in NZ, giving the providers little incentive to spell-out the well-known risks of owning a concentrated basket of shares or the practical difficulties of building a truly diversified portfolio.
Furthermore, investors in NZ need to consider the other consequences of direct share-trading versus holding managed funds – notably the tax benefits of using portfolio investment entity (PIE) structures and the tax risks associated with individual ownership of NZ and Australian shares.
While the subject is frequently glossed over, DIY investors in Australian and NZ equities can be deemed as traders by the Inland Revenue Department, potentially triggering capital gains tax liabilities.
What does a well-diversified global equities portfolio actually look like? A sample of a few of the international share funds on InvestNow offers a good guide:
- the Macquarie All Country Global Shares Index Fund invests in more than 1,500 individual shares;
- ANZ Investments OneAnswer International Share Fund holds over 350 stocks; and,
- the Harbour T. Rowe Price Global Equity Fund has a more concentrated portfolio of just over 230 individual shares – and has a higher volatility than the previous two funds to show for it.
Of course, many funds – including some available on InvestNow – might comprise only 30 or 40 underlying securities but investors typically use these concentrated portfolios as part of a broader strategy rather than the main event.
Holding a more-concentrated basket of shares will inevitably lead to greater volatility without necessarily delivering long-term returns above, or even equal to, a broadly diversified portfolio.
Given most individuals will never be able to directly own, or manage, a decently diversified equities portfolio of even the size of say, the Harbour T. Rowe Price Global Equity Fund, the share-trading platform promise of ‘democratising’ investment should be taken with caution.
‘Democratisation’ of share-trading may make for a winning catch-phrase but as a famous quote attributed to Warren Buffet puts it: “In the short-run, the stock market is a voting machine. Yet, in the long-run, it is a weighing machine.”
Light-weight regulation of the sector enables platforms to heavily promote self-managing shares as a harmless hobby without warning punters that it also comes with a significant risk of long-term wealth-loss.
Kiwi investors should apply some scepticism before piling their life-savings into a self-managed share portfolio with paid-to-trade platforms or brokers, selling impossible dreams and real dangers you would not read about in the brochure.
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