Risks of Individual Stock Investing: What Most People Overlook

By Justin May, Portfolio Manager

You might assume that picking a stock is like flipping a coin, with half of stocks doing better than average and half doing worse than average.

That’s wrong. And the misconception will probably hurt your investment returns.

As odd as it sounds, the average stock does worse than the overall market. Here’s why: a small percentage of stocks do wildly better than the market, and most lag. If you invest in funds that own the entire market, you’ll benefit. But if you believe your few stocks are likely to “beat”, or even keep up with, the market: beware. The odds are against you.

This is true in part because of simple math. The worst a stock can do is lose 100% of its value; in other words, you can only lose what you invest. But the upside is unlimited: a single stock can return five, ten, or even more times your initial investment. These rare winners can easily offset a few misses. The graphs below show the impact of this little-understood truth.

Histogram of individual stock returns over a one-month holding period showing a symmetrical distribution around 0%

The x-axis represents return versus the market (the market’s return is 0). The y-axis shows the number of stocks at each level of return. Over one month, stock performance follows a normal distribution, where most stocks perform about as well as the market.

Distribution of one-year individual stock returns showing a wider spread and growing downside risk

Five-year stock return distribution skewed by a higher number of significant losses and a long right tail of gains

Over 5 years, the trend emerges – a greater number of stocks lag the market (left of 0% on the x-axis), and a small number of winning stocks emerge, some returning multiple times that of the market.

Ten-year return histogram showing most stocks underperforming and a few generating high positive returns

Twenty-year individual stock return distribution with the majority underperforming and a long tail of outliers with extreme gains

Over 20 years, the picture is clear. The distribution is skewed heavily to the left of 0%, meaning most stocks underperformed. A small number of companies outperform, and some to an extreme degree. These companies account for much of the market’s performance.

Research by Antti Petajisto concludes that the average (median) stock underperforms the broad market by about -8% over 10 years, or -.8% per year. That may not sound like a lot, but it adds up. This underperformance rises to about -18% over 10 years, or -1.9% per year, when observing only the top 20% of performers over the previous 5 years. In other words, if you tried to pick stocks by selecting those that did best recently, your odds are even worse. Further research by Dimensional Fund Advisors reiterates this concept.

This matters especially to anyone holding a large position in one or several individual stocks. If you're expecting your favorite stock to keep outperforming, or even to keep up, it's important to recognize that the odds are against you. Understandably, many investors are reluctant to sell out of their favorite stock, because it has done so well in the past and you’ll likely create a large tax bill. But failing to diversify isn’t like betting on a coin flip, with 50/50 odds. It's like playing the slot machines. You are likely to lose.

Data sources:

Petajisto, Antti, Underperformance of Concentrated Stock Positions (June 30, 2023). Available at: https://ssrn.com/abstract=4541122 or http://dx.doi.org/10.2139/ssrn.4541122

Crill, Wes, Singled Out: Historical Performance of Individual Stocks (May 11, 2022). Available at: https://www.dimensional.com/us-en/insights/singled-out-historical-performance-of-individual-stocks