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The Danger of Stock Picking

Individual stocks — even relatively stable large caps — expose investors to a wide range of potential results.

ETF assets have grown to nearly $2 trillion for a number of reasons, but much of the growth can be attributed to the ability of the exchange-traded structure to provide cheap diversification across a variety of asset classes. The first part of that feature — cheap — tends to get most of the attention. But like their mutual fund predecessors, ETFs also deliver value by simplifying the process of portfolio diversification. 

Most Finance 101 courses illustrate the reduction in volatility that comes when the number of holdings in a portfolio increases (assuming less than perfect correlation of course). Below is a quick refresher on these principles, in the form of a chart showing the one-year performance for all S&P 500 stocks as of August 31, 2015. (Stocks are sorted in descending order by market capitalization.)

The best performing stock over this period, Electronic Arts (EA), was up about 75 percent. The worst, Chesapeake Energy (CHK), was down about 71 percent. When investors make big allocations to single stocks, these extreme scenarios are in play.

The tails around these extremes are fatter than many investors might imagine, especially over relatively short periods of time such as a single year. The chart below shows the likelihood that an S&P 500 component delivered certain undesirable performances:

Almost one-third of S&P 500 stocks lost 10 percent or more, and 15 percent lost at least a quarter of their value. If an entire portfolio was invested in a single stock, there is a 3 percent chance that it lost at least half of its value in a year.

A diversified allocation, the S&P 500 SPDR (SPY), didn’t exactly blow the doors off; it was up just 0.4 percent during this period. It avoided the extremes at either end of the performance distribution spectrum. The result was much less desirable than picking a winner — such as EA, AMZN (up 51 percent) or SBUX (up 43 percent) — but certainly preferable to losing half of the value.

About the Author: Michael Johnston

Michael Johnston is senior analyst for ETF Reference, and also serves as COO of parent company Poseidon Financial. His investment expertise has been featured in The Wall Street Journal, Barron’s, and USA Today, among other publications. He resides in Chicago.


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