Michael Batnick wrote a great post this week about a reader with a friend who invested his entire brokerage account in a single stock (Facebook). It’s hard to argue with an investment strategy when someone shows you eye-popping returns in their personal account. Although you know about the importance of diversification and the benefits of index funds, hearing this type of story can cause jealousy, a fear of missing out (FOMO), and the thought “if my friend did it, there’s no reason I can’t do it too.”
As Batnick points out, one of the major problems with holding a portfolio of volatile stocks is the emotional swing. Huge drawdowns scare investors into selling when they should be buying. Rapid gains entice people to buy more shares when they should be trimming an oversized position. So even if a stock performs well over time, the investor’s emotional mistakes eat away at their returns.
If someone asked me if they should hold individual stocks, I’d ask them a few questions. First, I would ask them how they handle volatility. Have drawdowns ever caused them to sell their stocks or go against their long-term plan? If that’s the case, I would encourage them to take a hands-off approach.
Second, I’d ask what they like about the company they want to invest in. If someone loves reading about business and can speak passionately about capital allocation, brand, long-term strategy, or return on equity, I think they’re fine investing some percentage of their portfolio in the stocks of companies they believe in. Engagement and interest will lead them to save and invest more.
My friend did it, so why can’t I?
There’s another point I’d make to someone who hears about a friend’s amazing single stock returns. Their friend may have picked a good stock, but that doesn’t mean they’re a good stock picker.
Let me explain. There is a fundamental principle in forecasting: a prediction’s apparent “success” doesn’t prove it was a good prediction. This idea is counterintuitive, and is one of the most common misconceptions in probability.
Imagine I said there is a 95% chance the New England Patriots will win the Super Bowl next year. Vegas oddsmakers would laugh in my face. There are 31 other NFL teams who follow the same rules. Even though some teams are better than others, forecasting that any individual team has a 95% chance of winning the Super Bowl would be crazy.
But what if the Patriots did end up winning the Super Bowl? Was my initial forecast of 95% proven “correct” given the outcome? No, because the ex-ante probability of an event is separate from the outcome. If you replayed the season 1,000 times, the Patriots wouldn’t have won 950 Super Bowls.
Similarly, if I claimed “I have a 100% chance of rolling a six on this dice roll,” and then I happen to roll a six, that doesn’t prove me right. It proves me lucky.
It’s important to remember this point when judging an investor: don’t assume someone is a great stock picker based on a sample size of one. With a sample of one, the best you can do is decide if their stock pick made sense at the time, before they knew the outcome.
So Michael Batnick is right, there are plenty of pitfalls investing in a single stock, even one that performs well over time. Excessive volatility triggers emotional decisions, and emotional decisions are usually mistakes.
But you should also not assume your friend is the next Peter Lynch because they got a great return on a one stock. More information is needed.