From Alexander Weis and Gerd Kommer
This post was updated in August 2024.
Many private investors interested in the stock market, including young male investors and those who have commercial knowledge for professional reasons, still believe that the best way to invest in stocks is through individual stocks, i.e. through stock picking. In our view, this is a false conclusion for the five reasons outlined below. There are only two rather weak arguments in favor of investing in individual stocks.
(1) Individual investments and risk
Individual stock investments mean more risk with only the same statistical expected return - an objectively worse deal. This is not an assertion on our part, but a finding from science for which Harry Markowitz and William Sharpe each received a Nobel Prize in Economics and which has been confirmed in an innumerable number of empirical studies over the past 60 years.
Investing in individual stocks means exposing yourself to around twice as much ongoing fluctuations (volatility) as with a globally diversified stock portfolio - with no statistical prospect of this increased risk being compensated for with a sufficient additional return. Secondly, there is always a risk of total loss with a single stock, but there is no risk of total loss with a broadly diversified ETF stock portfolio made up of thousands of individual stocks. Thirdly, if an individual value falls sharply, there is never 100% certainty as to whether this individual value will “come back”. However, with a globally diversified stock portfolio you know this for sure. The only uncertainty is how long full recovery will take. [1]
We have the surprisingly short statistical life expectancy of listed and unlisted companies here analyzed.
Investing in individual stocks simply means more risk without more opportunity. We show how surprisingly risky even Apple, the “best stock in the world” for many, has been since its IPO in 1980 here.
(2) The time required for investing in individual securities
Single value investments require more time and effort. The investor could invest this greater amount of time more profitably in other areas. This can be within the financial markets, but there on the right construction sites that move the speedometer needle in the right direction in terms of return and risk more reliably than speculation with individual values, e.g. B. the asset allocation between high-risk and low-risk asset classes. Investing time more productively can also happen in other areas of life - life partner, family, friends, hobbies, charitable activities, job or professional training, i.e. "human capital". (Here a video from us on the topic of human capital investment.)
(3) Operational risk and individual investments
Single-cap investments mean more operational risk - a risk that is consistently neglected and overlooked in the retail investing community and the financial media, even though operational risk is a "huge issue" within the risk management function at every large company.
Operational risk (OpRisk) is not about investment risk in the narrower sense, i.e. the risk of short- or long-term losses in the value of an investment that arises from the investment itself or the market. Rather, OpRisk means the possibility of losses resulting from one's own practical implementation, from personal implementation, from the implementation of a specific investment or a specific investment strategy, which would not have arisen if implemented correctly.
An illustrative example of OpRisk is the “fat finger problem”, i.e., in general terms, the risk of typing or otherwise making a mistake when entering an order (buy, sell) for a capital market investment if this typo or other error leads to a disadvantage - an immediate loss or opportunity cost in the form of a lost profit.
(4) Are individual stocks “structurally” safer than ETFs?
It is an old wives' tale that cannot be eradicated and can never be proven with hard facts, that individual values in a "mega-crisis" such as e.g. B. in the event of a third world war, they are infrastructurally or legally safer than ETFs that invest in these individual stocks. During such a crisis, would a stock exchange have to close for a longer period of time due to government regulations, such as: B. the German stock exchange during the Second World War, this would of course affect individual stocks just as much as ETFs. (The US stock exchanges and many other national stock exchanges outside of Europe were also open during World War II.) Exchange closures would not, moreover, preclude the possibility of off-exchange sales (over-the-counter trading). In general, individual assets are stored and traded in the same international infrastructure of banks, stock exchanges and specialized investment services companies as ETFs and other investment funds. If this architecture (these systems) collapses, it naturally affects individual values in the same way. In such a crisis situation, other assets such as real estate, life insurance, and unlisted company investments would probably be even more severely affected by market-related and/or legal obstacles to sales. A related pro-single stock argument is that the legal structure of investment funds in general and ETFs in particular may not be safe in a severe crisis and from this risk perspective one would be better off with single stocks - also a mistake, see argument 12 in this blog post.
(5) Leveraging is smarter than investing in individual stocks
Many people invest in individual stocks (practice stock picking) because they believe that this way they will achieve a higher long-term return than through broad buy-and-hold investing (passive investing). Kommer has shown many times in his investment books how questionable this belief is from a scientific perspective, e.g. Am this one.
However, even for those who are not convinced by the scientific research on the unattractiveness of stock picking, there is a superior way to increase the expected return on a stock portfolio than with stock picking. This rational way consists of using credit leverage, in modern German Leveraging, i.e. by adding a credit-financed part to one's own investment, in modern German in increasing the share "exposure" through credit leverage.
Here is a practical example: Philipp owns a globally diversified stock ETF worth 100,000 euros. It is a “100/0” equity portfolio, he has no risk-mitigating interest-bearing investments in his portfolio. If the global stock market rises by 10% in the relevant time frame, Philipp earns 10%. [2] However, that is not enough for Philip. He takes out a loan of 40,000 euros and uses it to buy additional ETF shares. He is now invested with 140,000 euros. The stock market rises again by 10%, i.e. 14,000 euros. Based on his equity investment (EK), this is 14,000 ÷ 100,000 = 14% (excluding taxes, interest and costs). In the alternative scenario, the stock market falls by 10%. For Philipp this means an equity loss of 14%.
Credit leverage increases (levers) the upside and the downside, just as is the case with individual security investing. However, from a scientific perspective, leverage is the smarter way, see e.g. b. here. We see it the same way. We examined the advantages and disadvantages of leveraging a diversified stock portfolio in detail in our own blog post (here) and consider moderate leverage to be a superior solution to concentrated investing in individual stocks.
(6) Withholding taxes and investing in individual stocks
Another, often overlooked, special disadvantage of individual stock investments lies in the area of withholding taxes on dividends. However, if you, as a private investor resident in Germany for tax purposes, limit yourself to fund investments, including index fund investments, this generally labor-intensive, annoying issue is completely eliminated. Mainly because the so-called partial tax exemption applies to UCITS funds under German withholding tax law, which offsets the foreign withholding tax burden across the board, so that manual retrieval and/or crediting in the income tax return is no longer necessary. [3]
We believe that there are only two arguments in favor of investing with individual stocks. The first is rather weak, the second is just a purely subjective, emotional argument.
Lower costs for individual investments?
(a) Yes, with a portfolio made up of individual stocks, it is conceivable to reduce the long-term “all-in costs” of a portfolio slightly below the low level that would arise with broadly diversified ETFs on a buy-and-hold basis. To do this, however, three requirements must be met, which are not the case in the actual practice of most individual investors: The portfolio must not contain too many individual securities and only a few “exotic stocks” relative to its size, for example the shares of a small Canadian platinum mining company. Furthermore, only limited trading (buying, selling) is permitted per year.
The entertainment value of individual stocks
(b) Direct investments in individual stocks or bonds are simply more fun for some investors. For these investors, capital market investments in general and stock investments in particular are not just a necessary evil in the context of long-term wealth creation and retirement planning, but rather an exciting, exciting leisure activity that - unlike, for example, B. Hiking, playing cards or an aquarium, but similar to playing the lottery - it also allows you to dream of “financial freedom” or quick wealth. (We have written a blog post about the rubber term “financial freedom”, which everyone, really everyone, understands and defines differently and which many book authors or YouTubers obviously interpret in a manipulative way - here).
Conclusion
Economic reason speaks against investing in individual securities for normal private investors:
The only objective advantage of investing in individual stocks is the possible entertainment factor (fun) it can bring to individual investors. In addition, from our point of view, investing in individual securities actually only has disadvantages: relative to a globally diversified ETF stock portfolio, it means more risk without any statistical hope of a corresponding additional return, more work and time expenditure, and disadvantages in terms of withholding tax. An individual investor will only achieve lower costs than an ETF investor if he limits himself to a small number of individual securities and trades little.
Endnotes
[1] The global stock market is a structurally resilient organism, whereas an individual company is a structurally fragile organism.
[2] For the sake of simplicity, we ignore any taxes and costs.
[3] This statement does not apply to the constellation of a so-called asset-managing GmbH based in Germany. With these, the withholding tax balance between individual stocks and ETFs is different.