Over the past 5 years, 34% of individual U.S. stocks lost money. Over the same time period, only 0.2% of U.S. stock mutual funds or ETFs (Exchange Traded Funds) lost money. Diversification reduces risk! This is according to an analysis by Morningstar, a market reporting company. Over that same 5-year period, the average annual increase of the U.S. market was 15.2%.
Here is the chart from Morningstar’s report:
Diversification is a key part of reducing risk:
I have clients who are hesitant about investing in the stock market because they have been burned by an individual stock in the past. This isn’t too surprising because even in a growing, bullish market like the last 5 years, you had a 1 out of 3 chance of feeling burned by an individual stock, according to this data! The solution to this fear is also shown in this analysis: DIVERSIFICATION! Buy a broad portfolio of stocks in a mutual fund or ETF, and you have a much smaller chance of losing money.
Risk vs. Return:
There is a basic trade-off between risk and expected return in investing. The riskier the investment is, the greater the expected return that investors will require in order to invest their money. Diversification has been called “the only free lunch in investing”. It takes individually risky investments, and by bundling them together, makes them less risky as a group for the same return than their individual parts.
Additionally, there is extensive research that suggests not only are you more likely to lose money by holding individual stocks, but it is very difficult to outperform the growth of the total stock market by trying to pick and choose stocks. 75% of professional stock pickers underperform their benchmarks (https://www.spglobal.com/spdji/en/spiva/#/reports). Because of this, the best mutual funds and ETFs to buy are low cost, index funds, not what are called “actively managed” funds.
Bottom Line:
Don’t invest in individual stocks. You have a much higher chance of losing money than if you invest in a mutual fund or ETF. Since there is evidence that a majority of professional stock pickers are unable to reliably beat the market, the highest expected return strategy is to purchase low cost, index-based mutual funds or ETFs.