June 26, 2025

Episode 363: The (Underappreciated) Risk of Individual Stocks

June 26, 2025

What if holding just a few “winning” stocks is riskier than it seems? In this episode, Ben and Cameron explore the hidden dangers of concentrated portfolios and unpack the data that makes a strong case for diversification. Drawing from research by Hendrik Bessembinder, J.P. Morgan, and others, Ben lays out the harsh reality behind individual stock returns: the odds are stacked against long-term success. From skewed return distributions and catastrophic losses to behavioral traps like the endowment effect and familiarity bias, this conversation breaks down why most stock pickers lose—and why diversification remains the only “free lunch” in investing. Whether you're holding onto a single stock for tax reasons, overconfidence, or just inertia, this episode is a must-listen reality check on portfolio risk. They also share thoughts on advisor adoption of indexing, the slow shift in Canada, and how a Rational Reminder YouTube video sparked debate between stock pickers and indexers in the comments section. For anyone navigating concentrated positions—voluntarily or otherwise—this episode is packed with data-driven insight and real-world takeaways.

Key Points From This Episode:

(0:00) Welcome to Episode 363: catching up in person and the value of working together in-office.

(1:07) Why advisors are slow to adopt indexing—and how culture, compensation, and inertia play a role.

(2:58) Demand is rising: indexing awareness among young advisors and investors continues to grow.

(4:08) Main topic: The hidden risks of individual stock concentration.

(5:40) The Nortel example: taxes, timing, and the illusion of "free" stock.

(6:51) Individual stocks are far riskier than most people realize—especially recent winners.

(9:09) Most investors hold between 3–7 stocks. Why that’s a problem.

(11:29) Portfolio concentration = fugu prepared by an amateur chef.

(12:45) Diversification reduces risk without reducing expected return.

(14:04) JP Morgan’s “Agony & Ecstasy” report: 44% of stocks suffer catastrophic losses.

(16:26) Why investors overweight the chance of a big win and underweight the risk of losses.

(17:07) The reality of skewed returns: a few big winners, many losers.

(24:35) The 2023 study on concentrated stock positions: recent top performers underperform the most.

(28:40) How many stocks do you need for real diversification? Way more than 20–30.

(32:00) Wealth dispersion and the long-term consequences of concentration.

(35:24) Why even 100-stock portfolios only beat the market 47.5% of the time.

(36:55) Taxes, control, and psychological hurdles make diversifying even harder.

(38:14) Diversification depends on your preference for risk and skewness—but beware the odds.

(39:08) Behind the scenes: Ben’s research process and content development workflow.

(43:14) Ben’s guest appearance on Morningstar’s The Long View.

(44:00) Meetups, t-shirt scarcity, and what’s next for PWL outreach.

Read The Transcript:

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix, Chief Investment Officer at PWL Capital and Cameron Passmore, CEO at PWL Capital.

Cameron Passmore: Welcome to episode 363. Great to be back on. Great to see you, Ben. Great topic today.

Ben Felix: Great to see you too. It's a rare week where we've seen each other twice in person.

Cameron Passmore: In person and you had a chance to get back to your home studio, but it is nice. We had a great day here in the office actually to have lots of people in. So Tessa was in, your sister, which is always fun and lots of other people.

Ben Felix: Yeah, it was good.

Cameron Passmore: We try to do a weekly breakfast, but the breakfast place we would go to shut down, unannounced to us. Bit of travel and stuff. So we finally got back to it today at a local diner. So fun to get that tradition back and seeing people again, which is good. Work from home is great. Work from home is very productive and efficient, but being in person, you pick up on stuff and kind of get a different gauge on the temperature of everybody.

Ben Felix: Yeah, it's a different feel for sure. It has been nice to run into people in the office. Also, very nice to be able to work from home.

Cameron Passmore: Oh my gosh, absolutely. I got a question for you around this, but something I've been thinking about lately as we've been talking to lots of advisors about their futures and whether or not they might want to join the movement that we're part of is you got to think what the low level of adoption of index funds, dimensional, whatever markets work, systematic framework, you got to think awareness of that is increasing inside the advisor community. However, the uptake is so slow. So I just kind of have an open question, like are there advisors out there, do you think that are actually wanting to make this transition?

But often in some of the larger firms, you might be the black sheep if you do that. So you might be ostracized, you don't have the support you want. There might be perhaps compensation conflicts of interest because there's so much more total overall revenue from active portfolios versus index funds. It's a dynamic I just find interesting.

Ben Felix: That piece I think is getting better because even in the old mutual funds channel where I started, where you couldn't sell a fee-based fund if you wanted to and you couldn't sell an ETF if you wanted to, those channels are much more open now to fee-based products and to ETFs in some cases. Let's name a conflict at that point. That was just a structural inability to use those types of products. That's gone away. I have talked to advisors who are in that channel or similar channels or similar environments and are realizing that maybe this index investing thing does make a lot of sense because you focus on the planning, you focus on the client, which is what people in those channels are trained to focus on anyway. But there's just this weird actively managed fund thing going on.

But I think there's more awareness coming about the benefits, not just to the client's performance or expected performance, but also to the overall quality of the relationship that an advisor can have with a client when the investing piece is treated as solved or whatever you want to call it, the way that we treat it.

Cameron Passmore: Not to mention the demand side. There has to be more consumers demanding this. The awareness has to be going up. We're playing a small part of that, but I listened to David Chilton's podcast yesterday and he mentioned the power of index funds and he highlighted this podcast and your YouTube channel on that in his conversation with Amanda Lang, which is a great conversation. But that awareness is increasing all the time. It's the demand side. I'd also add, you look at the people that we've been fortunate enough to meet and have joined our team as young advisors. The young crowd certainly understand this and get it. Yes, we have a biased sample, granted, that's why they wanted to come here, but the young people are so aware of this has been my experience. I just find the dynamic interesting and if there are advisors out there that might want to be part of a team that does things this way, we'd be open to a conversation.

Ben Felix: It's been happening since Dimensional came to Canada in 2003. They've been slowly adding more and more advisors in Canada. Lots of people that we now know, Cameron, but even 10 years ago, a lot of those people that are in that community were not investing this way. We know from the data too, that shift is happening. It's just happening more slowly in Canada.

Cameron Passmore: Sure is. The topic for today?

Ben Felix: Main topic today is the risk of individual stocks.

Cameron Passmore: This is antithetical to index funds. It is. Should we get into it?

Ben Felix: Let's get into it.

Ben Felix: A lot of investors hold concentrated positions in individual stocks. That can happen a lot of different ways. I have a line here that's kind of a joke, but it can happen when you hear Charlie Munger say that diversification is for the know-nothing investor without realizing that he's talking about you. Kind of a dig at people because Charlie Munger has said that, but I think a lot of people hear that and say, well, that's not me. I'm not the know-nothing investor. I'm going to hold a concentrated portfolio because Charlie Munger said so. Of course, Munger when he was alive and Buffett are very different from most people. I think a lot of people do hear Buffett and Munger talk about diversification being silly and concentration being smart if you know what you're doing. People hear that and think, well, I know what I'm doing, so I'm going to concentrate my portfolio.

That's one. It's kind of like an overconfidence type thing I guess. Then there are other reasons like being part of a company that went public and holding onto your stock either because you wanted to because that's what everyone else was doing or because you were in a lock up or whatever and the price went up.

All of a sudden, you've got this huge position in a single stock or even just like a lot of people get a portion of their compensation in employer stock. It could be other things like owning stock in an employer that has just performed so well over time that it becomes a big part of your portfolio. I mean, I can imagine working at NVIDIA and receiving equity compensation and then all of a sudden it's like, oh, wow, I've got a very concentrated position.

Cameron Passmore: Or if you sell it and you had a low cost base. I'm sure I mentioned that discussion around a client that held Nortel a long time ago.

Ben Felix: I don't know if you have.

Cameron Passmore: It's a cool story. This goes back to Nortel soared in what, 2001 to actually get the price, doesn't matter. I think it was like in the low 100s.

I said one client that had this huge concentration position in that single stock Nortel and all I can say is tax will be so expensive. That was a tax advisor's advice. My colleague at the time did the math and said, well, if it goes down below whatever $91, you will evaporate all the tax savings. If you think there's a chance it goes below $91, you should sell it because it's irrelevant. Oh, no, no, no. Went back and forth. The advisor went right to the wall, convinced them to sell. They sold almost at the peak. We all know what happened to Nortel's share price.

Ben Felix: One of those types of stories where you look back and it's like, wow, a lot of those employees had huge concentrated positions in their employer stock.

Cameron Passmore: And they just loved the company, which is great. I think they'd done a butterfly transaction from Bell. I guess Bell owned Nortel and it spun out. A lot of people viewed the Nortel shares as free money, which of course it wasn't. Interesting dynamic that's 20 plus years ago.

Ben Felix: Yeah, it's a great example. It's super relevant to the topic that I'm going to go through here. In any case, however you end up getting there, owning this concentrated position in a single stock and to the point of the example you just gave, I don't think people are aware of how risky individual stocks are. We know that in aggregate, and this is kind of a Scott Sederberg stuff, but other people have covered this idea too. In the long run, in aggregate, stocks are probably a bit safer for long-term investors than I think a lot of people realize. I think individual stocks are way riskier than most people realize.

One interesting thing that comes out of some of the research that I'll talk about here is that that is especially true for stocks that have performed well in recent history. The chances of an individual stock that performed well in recent history underperforming in the future, the chances are greater and the magnitude is also greater. Which stocks do people tend to own concentrated positions in?

Well, the ones that have done well recently, not the ones that have done poorly. What I want to do in this episode is detail how risky individual stocks are, which again, I don't think most investors appreciate that, and also cover how many stocks are needed. There's no single right answer here, but I'm going to talk through just how to think about how many stocks are needed for a portfolio to be diversified and why it's more than the commonly cited 20 to 30 stocks, which is a number that I hear thrown around quite a bit.

That's a number that is based on research, but it's based on research that's from many, many years ago when we didn't know quite as much about financial markets, when risk was framed in a different way. One of the reasons I think this is an important topic is that it's pretty well documented that individual investors do quite commonly hold concentrated portfolios. I saw some research showing that at least in their sample, individual investors on average held between three and seven stocks, which is crazy.

I don't have really good data on this to confirm what does it look like if you go to Questrade accounts across Canada or TD direct brokerage accounts across Canada. What are those portfolios? I would love to know. I don't have those data, but if you talk to people who don't invest in index funds, but invest in stocks, or if you look at the investing subreddits where people are talking about the stocks they invest in and their portfolios, that three to seven number actually doesn't seem too crazy. That's anecdotal, but the three to seven is based on research, but anecdotally, it's not actually that crazy for me to believe that it's good data.

Cameron Passmore: I guess they haven't heard of Bessembinder.

Ben Felix: They probably have not, or they have and they think that they're holding the three to seven stock.

Cameron Passmore: You're right.

Ben Felix: That's the thing with Bessembinder, it cuts both ways.

Cameron Passmore: Cuts both ways, yes.

Ben Felix: That concentrated portfolio behavior that is more pronounced, and there was a paper on this too, that is more pronounced for investors who overweight the unlikely probability of a big win relative to the much more likely probability of losses or underperformance. If that's you, I suspect it's not many of our listeners, but if it is you, listener holding a concentrated portfolio of stocks, you're going to want to hear us out in this episode.

Cameron Passmore: Do you think it's the human's tendency to like stories over math? Stories of stocks can be very compelling, which can drive your conviction. I know there's no evidence. I'm just thinking of what could cause that.

Ben Felix: There's no evidence of that exactly, but if you go up a level of abstraction, there is evidence that people overpay for growth. I think stories are probably a big part of that. Narratives matter.

Individual stocks, of course, are exposed to something called idiosyncratic risk, and that's risk specific to that company, what its CEO happens to tweet or whatever random thing that happens specific to that company, separate from what's happening to the broader market or even to similar companies. It's a type of risk that does not have a positive expected return. In general, and this is pretty basic portfolio theory thinking, investors should try to avoid idiosyncratic risk by diversifying their portfolios.

A broadly diversified portfolio, like take a total market index fund, is primarily exposed to market risk, which is again, a risk with a positive expected return. Now, the cool thing about diversification is that it reduces risk without reducing expected return. You're reducing your idiosyncratic risk. You're not reducing your portfolio level expected return, which is why diversification has been referred to as the only free lunch in investing. Typically, if you want more expected return, you have to take more risk. If you want less risk, you have to reduce your expected return. Diversification is the exception.

Cameron Passmore: Exactly.

Ben Felix: Now, if diversification is the only free lunch in investing, I've got another joke here. I don't know. Let's see how it goes. Then portfolio concentration is like ordering fugu prepared by an amateur chef. Fugu is like poisonous puffer fish. If you prepare it wrong, then it's – Another joke is funny.

Cameron Passmore: Okay. If you had to explain a joke, it didn't really land.

Ben Felix: In my YouTube video on this topic, I did have a clip from the Simpsons with an amateur chef very nervously preparing fugu. I'm pretty sure Homer ends up getting poisoned, so maybe it was better with a visual aid.

Cameron Passmore: Such a great episode.

Ben Felix: A concentrated portfolio, what does that actually mean? We have to put some definitions around it. I'm going to call it a portfolio with a single position that makes up 10% or more of its holdings by weight.

Now, that is a figure that's based on one of the papers that I'm going to reference later in the episode. The most concentrated position would be holding one individual stock or maybe levering up one individual stock. I don't know.

One individual stock is as concentrated as you can get in a single position. Then each additional stock after that makes the portfolio more diversified. The reason that concentrated portfolios are problematic is that they allow the idiosyncratic risk, that uncompensated random risk of the individual company to have a meaningful influence on the outcome of the portfolio as a whole, which isn't great

That wouldn't be terrible if most stocks performed really well. If every individual stock earned the market returns, oh, who cares? We don't need to diversify. But the data on individual stock returns, they're pretty sobering. You mentioned Bessembinder, Cameron, and that's some of the data I will talk about, but there's a bunch of interesting research on this. One of the most accessible, and this one's been around for a long time too, I think Bessembinder does reference it in his paper, or at least he acknowledged it when we talked to him.

JP Morgan puts out this occasionally updated report called the Agony and the Ecstasy. It's all about individual stock returns. They look at the range of outcomes for individual stocks and they slice the data up different ways in various issues of this report. I think they've been doing it since 2005. They've come up with a few different versions of it. In the 2021 issue, one of the data points that jumps out at me, I just find fascinating is the frequency of catastrophic losses.

That's defined as a 70% decline in price from peak to trough, which is never recovered from. We're talking about the Russell 3000 here. 3000 stocks in the US market that make up a huge portion of the US market.

44% of companies that appeared in the Russell 3000 index from 1980 through 2020 experienced a catastrophic loss. Some sectors like energy, they slice it up by sectors, energy information technology, they have even higher frequencies of catastrophic losses. Staggering number. 44% of the stocks that appeared in the Russell 3000 index, which is representing most of the US market over this 1980 to 2020 period, experienced losses of 70% or more that they never recovered from.

Cameron Passmore: The question is how do you behave when that happens?

Ben Felix: That's part of the question, but it's also just what does that do to your financial future if that was your one stock? Exactly.

Cameron Passmore: Because it doesn't recover, so even if you behaved well and held on to it, it doesn't mean it's coming back like a typical market return.

Ben Felix: That's what I'm saying. We don't get that mean reversion that tends to make stocks in aggregate, the stock market, a little bit safer for long-term investors than I think people generally think. This idiosyncratic risk or the potential for catastrophic losses that you never recover from, it just makes individual stocks a lot riskier than I think people imagine them to be.

I don't think it should be too surprising. The first time I read that statistic, I was like, wow, I didn't expect it to be that high. Capital markets are highly competitive.

They're driven by creative destruction. Some companies are going to succeed to the point where they displace companies that had previously been successful. Some companies are going to fail or at least struggle to compete and that'll be reflected in their prices.

We know in aggregate, stock returns are positive and we expect that to continue for the same reason, creative destruction, but within those positive aggregate returns, there are going to be a lot of losers. Another interesting point from the JP Morgan report is that despite the S&P 500's incredible performance of the index as a whole, hundreds of companies cumulatively have been removed from the index over time due to business distress. That's also an interesting point because if you took that diversified portfolio of companies that were removed from the S&P 500, I think they've probably performed quite well, but it does drive home the point of creative destruction.

The other issue is the skewness point. The idea that by number of stocks, there are much more losers than there are winners. The winners tend to win really big, but there aren't as many of them.

Over the 1980 to 2020 period, 42% of stocks included in the Russell 3000 had negative absolute returns. Negative, 42% of stocks. 66% of stocks trail the market, trail the Russell 3000 as a whole.

10% did beat the market by a cumulative over the full period, 500% or more. In the JP Morgan report, they call those mega winners. That phenomenon, the distribution that I just described, that's called positive skewness.

Most stocks perform poorly, a few do exceptionally well. I think the investors holding individual stocks are overweighting the probability of holding a mega winner and underweighting the much more likely probability of holding a loser.

Cameron Passmore: So interesting to think of why. Is it the greed? Is it the over-optimism?

Is it you have an optimistic bias in general? Let's look at this evidence. Is it glass half full or glass half empty?

Ben Felix: That's an interesting question.

It takes all those characters to make a market. It's so interesting to think of what goes on.

Then when you think of who's on the other side of the trade, that's where my head goes. When you're buying or selling, there's someone on the other side, you have no idea who it is, but it's likely someone pretty sophisticated.

Ben Felix: Just by volume of trading, it probably is someone sophisticated.

Cameron Passmore: I assume if you get one right and it's a massive winner, it must be so intoxicating, that builds up your confidence, so we all get it. It's an incredible phenomenon.

Ben Felix: I've already released a YouTube video on this topic and the comments were fascinating because there were people who have beaten the market by picking stocks. They think that I'm completely insane for saying that you can't beat the market by picking stocks. Of course, they'd think that based on their own experience, but then there are also a lot of people who have lost a lot of money picking stocks.

They're saying, yeah, this video makes a lot of sense. Then in some cases, there are little comment discussions where the people who have made money picking stocks are debating with the people who have lost money picking stocks, whose experience is more representative of what people should expect. It's hard when you have a lived experience that's like I picked stocks and I beat the market, being convinced that you were lucky or that you won't be able to repeat that outcome again in the future.

That's not easy to convince somebody of because like, hey man, I lived it, I did it. In the video here, we can show the distribution of stock returns from 1980 to 2020. We'll pull the chart up.

What you can see is that most stocks underperform, as we've been saying. A relatively small portion match or beat the market and a few do exceptionally well. That's the positively skewed distribution.

That means, as per what Bessembinder talked about when he was on, if you're selecting a small number of individual stocks for a long-term portfolio, it is much more likely that you pick stocks that underperform than you pick stocks that outperform. That's why diversification makes sense in general and why total market index funds in particular, which hold all the stocks in the market are so hard for active management to beat. That intuition is detailed in a 2017 paper, Why Indexing Works, which shows using just a simple toy model that when the distribution of returns is positively skewed, randomly selecting a subset of securities from the index dramatically increases the chance of underperforming the index.

Then that simple model is, of course, validated by Bessembinder's paper, Mutual Fund Performance at Long Horizons, where he finds that the pre-fee returns of only 45.2% of actively managed US equity mutual funds beat the net of fee returns of SPY and S&P 500 ETF over the same period. That to me is crazy. That the pre, only 45% of pre-fee mutual fund returns before fees beat the net of fee returns of SPY.

Cameron Passmore: Wow. Pre-fee.

Ben Felix: Yeah, I know. It's wild. That's just the skewness. That's the skewness of returns.

You add in fees and it looks much worse. The fact that you're more likely to underperform before fees because of the skewness. Those are much more diversified portfolios.

Actively managed funds tend to be fairly concentrated, but relative to 10 stocks that an individual investor might hold, they're much more diversified. To your point, Cameron, about what is driving this, I think one of the reasons is likely that investors holding individual stocks think they know the companies that they own and that they understand the distribution of potential outcomes, the risks and opportunities that that investment represents. I would call that familiarity bias.

Investors are more comfortable with what they know. There's probably some illusion of control bias too, where investors feel like they have some level of control over the outcome because they've done research or I don't know, maybe they work at the company or they know the management or whatever. The reality that investors have to understand is that the factors that drive underperformance and the catastrophic losses that we've mentioned are really unpredictable.

The JP Morgan study has some interesting data on this. They look at how things like commodity price risks that cannot be hedged away, changes in government policy, deregulation and re-regulation of industries, foreign competition, trade policy and fraud by company employees in their sample are some of the completely unpredictable things that have caused past business failures. Their commentary on this is that these are just things that no matter how well a business is run or how well you understand it, they can completely blindside its profitability, which can lead to big stock price declines.

Another thing is the declines happen quickly and unexpectedly. Another one of the comments on my video on this is that, oh, you've never heard of a stop loss. I guess if you have that in place, maybe it'll help on the downside.

I think these declines happen quickly and unexpectedly. The 2024 issue of JP Morgan's report, they show a chart with a sample of companies that have experienced catastrophic losses. They've got the magnitude of a loss on the Y-axis and the maximum monthly rate of decline on the X-axis.

It shows that companies of all sizes have experienced big losses that happen really quickly. The average monthly losses are just enormous. By the time that it's going down, it's in many cases going to be too late.

The other thing is once it's going down, people will want to hold on to it until it's recovered. Until it comes back up, that's the disposition effect. With the catastrophic loss data, we know that in a lot of cases, once the stock goes down like that, there's a good chance that it never recovers or even continues to decline.

I think another interesting point is that from the JP Morgan report again, people often believe that this company, whatever it is, I don't know, maybe Bell is a good recent example, that catastrophic losses can only happen to companies with weak financials or overvalued companies or companies within certain risky sectors. The reality is they happen across sectors. They happen to profitable companies.

They happen to companies with moderate debt ratios and to companies with reasonable valuations. I think that's another just important point is that investors have to realize that even a well-run and successful business can suffer the catastrophic losses or extreme underperformance. Another interesting one from that report is that investors will use analyst consensus.

I've talked to real people who do this. Well, I think I'm going to hold the stock because the analyst consensus said strong buy. JP Morgan looks at that too.

They find that the vast majority of catastrophic losers in their sample actually were consensus buys or strong buys from analysts prior to their declines. No way to hide from that potential for loss. Going back further in time, so that JP Morgan study was going back to 1980, the 2018 Bessenbender study to stocks that outperform treasury bills.

They look at all US stocks that existed in the CRISP database from 1927 through 2016. They do find pretty similar results to what JP Morgan found. 42.6% of common stocks have a lifetime buy and hold return that exceeds one month treasury bills, which is crazy. People have heard those data from Bessembinder before and from us talking about these data. More than half a time, you're better off holding risk-free treasury bills than individual stocks over that time period, which is wild. 30.8% of individual stocks in this sample beat the value-weighted market, the index. That's pretty similar to the JP Morgan study. More than half of the stocks in the sample deliver negative lifetime returns. That one is higher than the JP Morgan study.

I think that's probably because it includes all stocks, in this case, including the tiny ones that are in the CRISP database that are not in the Russell 3000. It also extends to the lifetime of stocks rather than the 1980 to 2020 sample period that JP Morgan used. The data in Bessembinder study are a little bit better at the 10-year horizon compared to the lifetime horizon.

At the 10-year horizon, 49.5% of stocks beat treasury bills, 37% beat the market, but still brutal numbers if you're picking stocks, hoping to beat the market. Then there's also the global skewness data. Bessembinder has his US paper.

He's also got a global stocks paper and the skewness in global stocks is even worse than it is in US stocks.

Cameron Passmore: You're not making a compelling case to stock pick.

Ben Felix: Well, I don't think there is one, really. It's the idea. This is a cool paper.

There's a 2023 paper, Underperformance of Concentrated Stock Positions. They use a set of all US stocks, but they exclude the smallest stocks from 1926 to 2022. The way that they describe their data is that in more recent history, it looks like the Russell 3000, but they also go back further in time when there were fewer stocks in their index, but they have a size cutoff.

They take a slightly different perspective, but they're again looking at concentrated positions. The author finds that the median 10 year US single stock return in their sample is a cumulative negative 7.9 percentage points relative to the market. That's about 0.82 percentage points in annualized terms. Also that 55% of individual stocks trail the market at the decade horizon. They also show how the volatility of a portfolio changes with an increasing weight in a concentrated position by modeling various portfolios consisting of the market index and an increasing allocation to an individual stock. What they find, this is where that 10% being the definition of a concentrated portfolio comes from.

They find that portfolio volatility is relatively unaffected by single stock positions at weights up to 10%, but then increasingly affected thereafter. The effects are more pronounced for individual stocks with higher idiosyncratic volatility, which makes sense. If you hear all this pessimistic data and think that well, nobody would buy a loser stock.

I only buy winning stocks or I only hold my stocks have been performing well. This is the fascinating data point from this paper. Stocks with top 20% performance over the past five years have a median cumulative return over the following 10 years of negative 17.8 percentage points relative to the market. That's an annualized 1.94 percentage points. 60% of these stocks as opposed to 55% of all stocks trail the market at the decade horizon. Recent winners, like the stocks that, like I said earlier, I would argue are the ones that are more likely to make up a larger portion of investor portfolios.

Those ones perform worse, not better at the 10-year horizon. Pretty interesting. That applies across all industry groups and also among both the smallest and largest stocks.

Like you said, Cameron, I'm not making a great case for investing individual stocks. I think the important takeaways from these studies are that positive skewness in individual stock returns means that you're much more likely to pick a loser than a winner when you're selecting an individual stock and the effects of skewness are more extreme at longer horizons. That means that the chances of being a successful long-term buy and hold investor with only a few stocks is increasingly unlikely at longer horizons.

However, like we said, Bessembinder cuts both ways. If you do pick the rare winners, the results can be extremely positive. The other thing is underperformance can happen quickly, unexpectedly and irreversibly.

A lot of stocks not only underperform, but they suffer catastrophic losses that they do not recover from, unlike a diversified portfolio, which tends to bounce back. It is worth emphasizing that it is true that a small number of stocks perform exceptionally well. It's just really hard to pick them before the fact.

Past winners are more likely to underperform than outperform in the future. Some level of diversification probably makes sense, as we know. That's another interesting question though, is how much diversification makes sense?

Individual stocks are risky, fine. We should diversify, fine. How many stocks should you own?

What is a diversified portfolio? There are a couple papers, very highly cited papers from the 1970s and 80s that find a 20 to 30 stock portfolio is sufficient for diversification. The way that they approached is that beyond that point, the risk reduction benefits diminish.

That 20 to 30 stock finding has colored the beliefs of many investors. The problem with it is that it assumes that volatility is the only measure of risk that matters to investors. They show that the volatility reduction benefits of additional stocks levels off after 20 or 30.

I would argue that what matters to investors is the expected distribution of long-term wealth outcomes, not the short-term volatility. If you think about a more concentrated portfolio, has a small chance of holding the mega winner and a much larger chance of holding the losers, even if they have similar volatilities, I don't know if they would, but say they have similar volatilities, the difference in wealth accumulation between the worst and best concentrated portfolios is going to be huge. It's going to be enormous at long horizons.

Reducing volatility is for sure a good thing. That's one of the things that diversification can help with. The other interesting thing is that at very long horizons, even small differences in volatilities can have big impacts on long-term wealth accumulation.

Cameron Passmore: Really interesting.

Ben Felix: talked about this in some of our earlier way back episodes about concentration versus diversification in factor investing. We talked to Wes Gray about that.

Cameron Passmore: Gray, exactly.

Ben Felix: It is a very interesting topic. There is a 2022 study by Roni Izrailov, how many stocks should you own?

They simulate long-term wealth outcomes for portfolios with varying levels of concentration. They find that the 25th and 10th percentile outcomes, basically the worst outcomes in their simulations, improve quite dramatically until around 250 stocks are included. Then the incremental benefits of diversification really decrease after that.

The average portfolio in their simulations multiplied wealth 19 times over 25 years on average. An investor with just 25 stocks had a 1 in 10 chance of receiving less than a 12 times multiple. An investor with 250 stocks had a 1 in 10 chance of achieving less than a 17 times multiple of wealth.

See that distribution is a lot wider. The left tail is a lot worse with a more concentrated portfolio. The worst outcome is less bad.

The best outcome is also less good, which is interesting because that's not necessarily a good or bad thing. It does make the choice about how diversified a portfolio should be a preference more than a prescription. You can't just say, well, you should have this many stocks.

I think it's worth highlighting that when risk is measured as the variability of terminal wealth, the diversification benefits of adding more stocks does continue far beyond that 20 to 30 holdings that sometimes get cited. If you're confident you can pick winning stocks before the fact, portfolio concentration can make sense, but the odds are stacked against you. The track record of active management in general does leave much to be desired as we know and as we mentioned with Bessembinder's research.

It is worth saying that some investors may be comfortable with that risk. They may be willing to accept a wider range of long-term outcomes, including a good chance of trailing the market or even suffering a catastrophic loss in exchange for a smaller chance at extreme outperformance. It's like a preference for a lottery like payoff, which you can't say is right or wrong, but I think it is just a risk that needs to be properly understood for anybody holding a concentrated portfolio or for holding a single stock.

Bessembinder's do stocks outperform treasury bills. He simulates long-term returns for 20,000 portfolios of randomly selected 5, 25 and 50 and 100 stock portfolios. He finds at the 10-year horizon that even 100 stock portfolios outperform the market only 47.5% of the time. That was a crazy finding from his paper too. Now, there are a few different ways to interpret that result. One way is that, well, hey, it was only a little worse than a coin flip that you would have beaten the market before costs.

The other is that you had more than a 50% chance of trailing the market. Now, the nice thing about total market index funds and even I think I would group dimensional funds into that category because they still own that broad cross-section of all the stocks in the market. The nice thing with that approach is that you know you're going to get the market return in the case of dimensional plus or minus some factor premiums, but you know you're going to get the market return even if you don't know what the market's going to be.

With a really concentrated portfolio, you might still get the market return, but it's going to be plus or minus the active return from portfolio concentration. That range of outcomes for the active return is going to be a lot larger with increasing portfolio concentration and the distribution of outcomes of all the concentrated portfolios is going to have lots of losing portfolios and a few big winners. That skewness will decrease as you increase the diversification of the portfolio.

There is research from Vanguard showing that active share, which is not the same thing as concentration, but it is related. We actually have an episode with Martijn Cremers who created that measure coming up. Vanguard has research showing that higher active share results in a wider dispersion of benchmark relative returns for actively managed funds.

It becomes a question of how confident you are that the stocks you pick will be winners rather than losers, while keeping in mind that the distribution of individual stock returns is pretty intimidating. Another interesting point here is that portfolio concentration can have asymmetric effects on performance. There's a 2022 paper, Fund Concentration, a Magnifier of Manager Skill.

The author finds that increasing concentration has a pronounced positive impact on performance for outperforming funds, which makes sense. If you take more concentrated funds that have done well, they will have done well more so than more diversified funds, but the opposite is true for underperforming funds. This is a really interesting point though.

Higher levels of concentration generally hurt the poorly performing funds more than it helps the outperforming funds. This is another interesting point on the concentrated positions thing. We talked about a few different paths that you could have taken to end up with a concentrated position, but most of those paths lead to both or some combination of economic and psychological barriers to diversifying.

I think the biggest economic barrier, we talked about this earlier with the Nortel example, is taxes. You own a stock that increase in value substantially, leading to it being a concentrated position, there's probably a large tax bill associated with selling it. An important thing about in that case is that the taxes generally don't go away, at least not in Canada.

In the US, there can be some estate planning, but in Canada, the tax bill doesn't go away. The only thing you can do is control whether you realize the gain now or later, because it's coming no matter what. Deferring taxes can be a good thing, but in this case of a concentrated stock position, it is being traded off against taking a large amount of idiosyncratic risk.

There are some strategies in Canada like tax efficiently donating the appreciated securities that can make sense. If you're going to make a donation anyway, then this can make sense. Donating them for the sake of donating them when you wouldn't have otherwise, that's not really helping you with your tax bill.

It sort of is, but you're also giving away the assets. If you're going to make a donation anyway, this can be a very tax efficient way to do it. That said, it's a relatively complex planning and it's got to be approached very carefully and in the context of the overall financial plan.

Another less common economic constraint that can still be relevant is control. Some large shareholders of a company that have a concentrated position may need to maintain their large position in order to maintain voting control of the company. That's obviously a much harder one to overcome.

The psychological constraints to diversifying include the representativeness bias, where people ignore the types of base rate probabilities that we've discussed in this episode and assume that their past performance with a single stock is indicative of its expected range of outcomes. There's also the endowment effect, where people prefer things that they already own. There's the status quo bias to stick with the thing that you're already doing.

I own this stock, so I'm just going to keep holding it. It's easier to not make a decision than it is to make one. In the case of a stock that's fallen in price, we also have the disposition effect.

Managing those biases with respect to diversifying a single stock position can be challenging. A couple of things that can help. One is imagining that the amount you have invested in the single stock is in cash and asking yourself if you would buy the stock today.

Then another one, and this is one that I got from someone who I told the first one to, and I took it away and thought about it. They came back and said, I tried doing that. I tried imagining that it was cash and I wouldn't have bought it, but it didn't help me sell.

I was still stuck. They came up with something that did work for them, which was creating a systematic plan to dollar cost out of the concentrated position. It avoids the psychological impact of making one big decision and having it not work out.

Cameron Passmore: Makes sense. I'm still in the cash camp. I find that one pretty effective.

Ben Felix: I like that model too, but it doesn't work for everyone. If it doesn't work for someone and dollar cost averaging out, if someone says, I just can't do it, I can't sell the whole position, I like putting something systematic in place.

Cameron Passmore: It's tough being a human.

Ben Felix: What's tough investing as a human. Humans are not designed to be long-term investors in these abstract financial instruments that we call stocks. Stocks are extremely risky, as I hope we have articulated.

Most of them by number underperform the market. Many of them have negative long-term returns or more extreme catastrophic losses. A smaller portion of them have extremely high returns.

Picking any one stock is more likely to lead to a bad outcome than a good one. Counterintuitively from one of those papers, that is even more pronounced for stocks that have performed well over the last five years. The simple answer is to overcoming individual stock risk is of course diversification.

The extent of diversification that makes sense depends on your preferences for skewness. Some people might want skewness. Also your conviction in your stock selection ability and your willingness to bear the risk of a wider range of potential outcomes.

Then getting out of a single stock position, it can have economic and psychological challenges, but those can be overcome with thoughtful planning. That's something that we have seen many clients do.

Cameron Passmore: All right, you've convinced me. Mission accomplished. That's good. I'm a changed person because of this.

Ben Felix: Glad you're convinced. You're going to go sell all of your Tesla and Nvidia shares.

Cameron Passmore: That's right. I'll get on that right now. I have to ask you, where did this idea come from for this?

I'm just curious in the process. I'm guessing a lot of listeners have a similar question. Where did the idea for this specific topic come from?

Ben Felix: I don't know.

Cameron Passmore: Did this come out or does it come from a client or from a comment or just came to you?

Ben Felix: I can't remember.

Cameron Passmore: Some people think there's some sort of master communications plan behind all this and we've said many times, no, this is a pretty messy omelet making station.

Ben Felix: I'd love it if someone came to me and said, Ben, you should make a video about this, then I could do it.

Cameron Passmore: Here's my next question. You come up with a topic. What's your process to then go and discover it because you referenced many papers and studies here. What's your next piece of the process?

Ben Felix: For this one, I think it might have just been that there were a few papers that I had read on this, like the Bessembinder papers that everybody's kind of read. Everybody. I mean, maybe not everybody. I've read them.

Cameron Passmore: But they're familiar with a lot of people. It's fair to say that.

Ben Felix: And then there are the J.P. Morgan studies that I've read those before Bessembinder had written his 2018 paper. I was kind of aware of those. They're kind of connected and they're kind of slightly different data, slightly different ways of presenting the analysis.

Then there's the more recent one, there's the 2023 paper, the underperformance of concentrated stock positions.

Cameron Passmore: How do you find them? Do you go to SSRN and search or ChatGPT? How does that process happen?

Ben Felix: I have no idea. Sometimes it'll be something as simple as I'll be looking somebody up as a potential Rational Reminder guest. When I do that, if I've seen a few papers from somebody and I'm like, this person could be interesting.

I'll go and look them up on SSRN or on their university website if they're at a University. I'll go and just kind of flip through their papers, their working papers and their published research. In many cases doing that, they don't rank well on Google, academic papers.

I'll find a paper that I hadn't seen before. I think that's how I found the underperformance of concentrated stock positions. Then I go and read it and it's like, oh, it's another interesting perspective on that topic, on individual stock risk.

For this video, there were enough unique perspectives, the Bessembinder paper, there's the J.P. Morgan studies, there's the Anti-Pedisto paper that, I hope I pronounced the name correctly. That's the underperformance of concentrated stock positions paper. Then the Roni Israelov paper on how many stocks you should own.

That's probably enough content to talk about for a video. Then I just write it up into a video.

Cameron Passmore: You read them, you think about it, you get your outline, catalog the studies. I assume you get them saved in a database or something, you cross-reference.

Ben Felix: There's no database.

Cameron Passmore: It's just interesting how it all comes together.

Ben Felix: They're linked in my Google document. I do have all of my past video scripts and Rational Reminder episodes in a Google Drive folder. I will go back and reference them.

What was that study that we talked about? I'll go back. It's not quite a database and it's not very well structured, but it is there.

Cameron Passmore: Are you using AI much to help you to do all this?

Ben Felix: Off and on, I still find it pretty useless. Some people will probably be so offended to hear that or they'll think that I'm an idiot for not being able to use it properly, but it makes serious, serious mistakes. It's a little bit useful for finding obscure studies.

It's also useful for finding studies when you don't have keywords, but you have a more abstract idea of a topic that you want to read about or whatever. It's useful for that, but honestly, using Google Scholar is also pretty good. I do use it quite a bit, but I don't trust it.

Cameron Passmore: This helped you craft a YouTube video script and then you repurpose it effectively here, correct?

Ben Felix: Most of our podcast episodes like this, where we're delivering a topic or a video essay or whatever, usually I write that. Even if I don't end up making a video on my channel on the topic, I'll write it as if I were going to. I just find it works well to think about it that way because I have a target length that works well both for the podcast and for the YouTube channel.

In structuring the narrative, I find thinking about it as if I were going to speak it works well. Typically, I write it as a video and then we do it as a podcast episode.

Cameron Passmore: Do you ever have writer's block or do you ever find yourself, man, I don't have a topic. I got to scramble.

Ben Felix: It hasn't happened yet. It's been eight years or whatever. I don't know. Maybe one day. That would be pretty terrifying.

Cameron Passmore: Because it's not like we're recycling all the same topics over and over again. A lot of the common themes, yes, but it's not like a greatest hits that just keeps going on repeat.

Ben Felix: I did a video years ago on individual stocks and I went back and read that script after I'd written most of this one just to see if I had any other ideas in there that I hadn't already covered in this video. It was actually strikingly similar to that past one. Maybe I am recycling ideas now.

Cameron Passmore: Have we talked about your appearance on the Morningstar podcast here? I don't think we have.

Ben Felix: You and I haven't. I did mention it in one of the episodes with Dan, but that was a while ago. I was on Morningstar's The Long View podcast with Christine Benz and Amy Arnott. It was a good conversation. You should check it out.

Cameron Passmore: I found you super chill. Almost like you had some sort of, I don't know, relaxant or something. You're so chill and easygoing. You're like, sure. I found some of your answers so refreshingly normal.

Ben Felix: You had not told me that.

Cameron Passmore: It was a good conversation. It was really smooth. I called you the velvet fox or something. You're just so smooth and you seem chilled on the conversation. They were great, but your answers are very straightforward and they're well done, of course. Your answers are great.

It was a good conversation. They do a good job.

Ben Felix: I've been aware of their podcast forever, but I've binged listened to a few of them. We've got some good episodes.

Cameron Passmore: Separate topic, Ben, we've talked about bringing, not so much the show, but us hitting the road, doing meetups in various centers. I put it out there to listeners if there's advisors out there that might want to meet up in a different city. We're just thinking of getting back to where we did some meetups in Montreal and Toronto and Ottawa, which we would do those, of course, but perhaps go broader.

If there are people in different cities across the country that might like to help us coordinate something, let us know. We can do an RR type meetup or we could also do an advisor meetup.

Ben Felix: Let's be clear about it. Totally happy to do meetups and meet people that are listeners and stuff like that, but we would love to meet advisors that are potentially interested in joining our firm. That's one of our big objectives and one of the reasons that we did our deal with One Digital is to give us the capital to acquire like-minded advisors across Canada that can contribute to what we're building at PWL.

If those people are out there and want to meet up, let us know.

Cameron Passmore: My last question, which might be the most important one, are the premium t-shirts back in stock?

Ben Felix: I don't know. I have not asked Angelica or Jacqui, but let's check it out in the store here.

Cameron Passmore: Sold out. Sold out still. I just know we got a shipment in the office. I didn't know if there's any shirts in there.

Ben Felix: All sizes are sold out. That's wild. I knew they were going to be hot. I knew it.

Cameron Passmore: You were right.

Ben Felix: I predicted the market on this one.

Cameron Passmore: We got pictures of people in them and I know Will, a good friend of my daughter's, loves it. He's also a big fan, so shout out to Will, but loves the shirt.

Ben Felix: They're cool shirts. They look great. Well made. The contrast with the white and the black. It's such a good nerdy inside joke. I was talking with a doctor at a medical appointment, not cancer-related, just a checkup.

Although we did talk about that, obviously. He was like, what are those letters on your shirt mean? I was wearing the premium t-shirt and I was like, it's an asset pricing model.

It's a finance thing. I don't know. He was like, well, no, can you try and explain it to me?

I went through each premium and what it means. He's like, huh, it's really interesting.

Cameron Passmore: Look at you, always selling.

Ben Felix: I have nothing to sell. I'm just talking about asset pricing models. It's a real conversation starter.

Cameron Passmore: Which is what everyone should do with their doctor.

Ben Felix: Yeah. I guess so.

Cameron Passmore: Okay. Anything else going on? I know your renovations are progressing well in your front yard, so that's exciting.

I hope they can check it out.

Ben Felix: Progressing is, I don't know if I quite use that word. They have progressed. So funny.

Cameron Passmore: Okay. Anything else?

Ben Felix: I don't think so. I don't know if I answered the question about the premium t-shirts, but they are coming back. We have ordered more. They will be restocked. As of the time we're recording this, they have not been restocked, but maybe by the time the episode is released, I don't know.

Cameron Passmore: All right, cool. Well, beautiful June day in Ottawa. Love the summers.

Ben Felix: It's a bit humid. I grew up on Vancouver Island, BC where the summers are also nice, but we don't have the humidity out there.

Cameron Passmore: My travels this past month, I went from Vegas, which is super hot and bone dry. It was 41 degrees one day. Then I went to conference in South Carolina where it's super hot and like 100% humidity.

Now, I think we must be close to that here in the Ottawa area.

Ben Felix: It's humid. I remember the first time I was in Texas and the first time that I was in Vegas, it was just such a different feeling when you walk into the hot air. It's like, whoa.

Cameron Passmore: Oh, it just cooks you, but there's no humidity. You don't sweat from walking around, but man, it's hot. Given that they know how to do hot.

All right. Great topic. Great chat. Good to see you. As always. Good to see you and everybody. Thanks for listening.

Ben Felix: Thanks for listening.

Disclosure:

Portfolio management and brokerage services in Canada are offered exclusively by PWL Capital, Inc. (“PWL Capital”) which is regulated by the Canadian Investment Regulatory Organization (CIRO) and is a member of the Canadian Investor Protection Fund (CIPF). Investment advisory services in the United States of America are offered exclusively by OneDigital Investment Advisors LLC (“OneDigital”). OneDigital and PWL Capital are affiliated entities, however, each company has financial responsibility for only its own products and services.

Nothing herein constitutes an offer or solicitation to buy or sell any security. This communication is distributed for informational purposes only; the information contained herein has been derived from sources believed to be accurate, but no guarantee as to its accuracy or completeness can be made. Furthermore, nothing herein should be construed as investment, tax or legal advice and/or used to make any investment decisions. Different types of investments and investment strategies have varying degrees of risk and are not suitable for all investors. You should consult with a professional adviser to see how the information contained herein may apply to your individual circumstances. All market indices discussed are unmanaged, do not incur management fees, and cannot be invested in directly. All investing involves risk of loss and nothing herein should be construed as a guarantee of any specific outcome or profit. Past performance is not indicative of or a guarantee of future results. All statements and opinions presented herein are those of the individual hosts and/or guests, are current only as of this communication’s original publication date and are subject to change without notice. Neither OneDigital nor PWL Capital has any obligation to provide revised statements and/or opinions in the event of changed circumstances.

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