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About personal finance, investments and markets.
July 2, 2015

Should investors buy individual stocks?

Should private investors buy single stocks to get their equity exposure? Although there is clearly some entertainment value in trading shares for everyone who likes to follow the financial news, the overwhelming evidence from academic studies shows that individual investors trail market returns by a wide margin. To show how difficult it is to beat the markets, it is probably best to check the returns of Warren Buffett and the Hedge Fund community. Most investors, if they are honest to themselves, will probably agree that it is next to impossible to beat these super-star investors. But here is the really interesting part: even these super-star investors are struggling to beat the market! We are big fans of Warren Buffett and his frank comments and it is no surprise that his advice to investors is to buy cheap index funds and not try to beat the markets by buying single stocks.

The following two charts show the excess returns („alpha”) of Warren Buffett and the Hedge Fund community relative to the S&P 500. In both cases, we can see that the excess returns start from similar levels (around 6%) but continue to tail off over the next 15 years. Actually, most recently, even Warren Buffett did not achieve any excess returns while the Hedge Funds delivered negative alpha.

Buffett HF

Why do the excess returns show the same declining profile? Because capitalism works. The investment business can be very lucrative and is attracting some of the smartest brains worldwide. However, at the time when Warren Buffett started investing in the 1950s, the competition was probably not very fierce. Today on the other hand, universities in every country are churning out thousands of hopeful, hungry and intelligent analysts who are willing to emulate the success of Warren Buffett. More competition leads to fewer excess returns.

BRK - E2

Investing is truly a professional game. Nobody in his right mind would turn up at a Formula 1 race and expect to be able to compete with the pros. Private investors make similar mistakes when they take idiosyncratic and diversifiable risks. They do so because they are overconfident in their skills; they overestimate the worth of their information; they have the illusion of being in control and they don’t understand how many individual stocks are needed to effectively reduce diversifiable risks.

If you are still engaged in active management strategies, the question you should ask yourself is: If professional money managers are unable to outperform, what advantage or skill do you have over them that will allow you to outperform? If the answer is none, as it almost certainly is, then the logical conclusion is that you should abandon investing in individual stocks.

It is a fallacy to look at the performance of professionals, scoff at how poorly they have done and conclude from their poor results that you can do better. Most football players are not very effective at guarding Lionel Messi, but that doesn’t mean you could dominate him. The failure of other people to perform a difficult task does not mean that it will be easy for you to perform.

Source:
http://www.alphaarchitect.com/blog/2015/03/03/buffett-and-hedge-funds-share-a-trait-no-alpha/#.VP1n6fmG98E

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