Should You Buy Individual Stocks and Bonds?

You are the Sucker

“Listen, here’s the thing.  If you can’t spot the sucker in your first half hour at the table, then you are the sucker.”  - Rounders, 1998.

When you buy index funds, you are betting that over time, the stock market overall will rise. (A rising tide lifts all boats.) This has turned out to be a very good bet. So far, it has always been true.

If you buy an individual stock or bond, you are betting against the people selling it.

Let's say you're working for living, and you're pretty darn smart, and you've been studying investment for 5 or 10 hours a week for a few months or years. Who are you betting against?

Often, you're betting against someone who has the following characteristics:

  • Is very, very smart. Finance pays big bucks, and thus attracts the best and brightest in our society. (This is actually a serious problem for our society, but that's a different post.)
  • Is very, very well-trained. This person has an MBA from Harvard or Yale or somewhere equally impressive, and has been doing this full-time for years after being mentored by the best.
  • Works very, very hard. We're talking 60- to 80-hour weeks doing nothing else.

In addition, this person has the following resources:

  • Has a very skilled, very extensive network of support behind him, from skilled programmers making tools, to researchers and analysts who have huge libraries of data -- historical and current data that is often difficult or extremely expensive for a private individual to obtain.
  • Has more money than a lot of countries at his disposal.

In addition to the above advantages, which I think everyone would agree on, there's another advantage that's often unspoken:

  • These people have the ability to cheat. They have access to insider information, or the ability to move markets (raise or lower prices) by their words or actions, or by early access to deals or by a thousand other means that have never occurred to me or to most people who don't play in those leagues. The person selling you the stock may WORK at the company in question, and thus know far more about its potential than you do.

These people are elephants. Often, even they can't overcome these challenges, because when two elephants are jousting, one will lose. You are a mouse. Can you overcome these challenges? If so, why are you reading this blog? You have nothing to learn here. (But I'd welcome a guest post.) But if you're reading this blog, and you're here to learn, then you've got to realize that you can't reliably overcome all that. You may do so occasionally, but that's luck, not skill, and it's not repeatable.

Unique Risk

Let's look at another reason you shouldn't buy individual bonds -- the difference between market risk and unique risk.[1. Hat tips to the Mad Fientist and John Bogle.] Sometimes the entire stock market will go up or down, and it will carry most other stocks with it. Even if Apple/Google/Exxon/whatever is doing spectacularly, the market can go down and take an individual stock with it. This is market risk, and we can't get away from it.

Unique risk is the risk that an individual stock will go down separately from the market. I would have bet any amount of money that it's impossible to go broke by selling sugar and fat to Americans, but it turns out I was wrong. If you buy an individual stock, you are subject to market risk, but you're also subject to that stock going down because of mismanagement, a competitor getting an advantage, or just plain old bad luck.

Market risk is enough risk for anyone.

Diversification

You may plan to diversify using a do-it-yourself portfolio of 15 to 30 stocks. Bad idea. Here I'll just quote from Bernstein's "The Investor's Manifesto:"

You may have heard that you can get adequate diversification by owning 15 or 30 stocks. In a narrow statistical sense, this is true; a portfolio of a relatively small number of stocks is not much more volatile than the overall market on a daily basis. This fact misses a much larger point: Small portfolios, even with their low volatility, are more likely to send you to the poorhouse. Researcher Ron Surz constructed 1,000 random portfolios each containing 15 stocks, and then followed their performance for 30 years. The “lucky” portfolios at the 95th percentile or better returned 2.5 times the end wealth of the market, but the “unlucky” ones at the fifth percentile returned only 40 percent of the final wealth of the market.

Conclusion

Don't buy individual stocks or bonds. Period.

Postscript: But I'm Different

But, you may be thinking... what if I can do it? OK. You have the strength of ten because your heart is pure, and you still, after reading all the above, want to take on the big guns. OK. Decide how much you're willing to lose -- it should be the same amount that you'd take to Vegas to play with. Go ahead and play the market with my blessing. But know that you're gambling, and what you're doing is entertainment, not investing -- and if you lose your stake, do not put more money in. If you win, keep playing with your winnings -- but do not put more money in.