Note: If you would prefer the audio version of Investing Insights, click here to listen to our podcast Episode 6: How To Make Millions Speculating In Stocks.
Most of us have all dreamed of picking that one or small handful of stocks that generates massive, game changing returns for us. Another way to describe this dream is investing success through stock speculation. While I generally do not think stock speculation is a prudent investment approach, I do believe there is a right way and wrong way to speculate. Most stock speculators use the wrong approach, therefore virtually guarantying they will never achieve the massive returns they seek and most likely underperform the stock market as a whole.
For those of you who follow 3Summit’s research, you know, we strongly believe that superior returns come from decreasing a portfolio’s risk, not increasing it through stock speculation or what we would consider excessive allocations to stock risk. We believe risk reduction, when done properly, increases your potential long-term returns and that risk management is an underutilized source of additional returns in most portfolios. So, it might surprise you when I tell you I am not totally against investors trying to hit a home run by seeking to earn very high returns by speculating in stocks. I define stock speculation as the investment strategy of picking a relatively concentrated portfolio of individual stocks (usually 60 stocks or less), with the hopes of generating much higher returns than investing in the broad stock market through an index fund. I define much higher returns than the market as double the market returns or more.
The statistical probability of making an unusually large amount of money from stock speculation is so low that you would likely have better luck in Las Vegas. Betting money on casino games, where the statistical odds of success are against you, does not make much financial sense. On the other hand, I understand the entertainment value casino games can bring to gamblers. As long as you are only gambling the amount of money you can comfortably spend for a night out, what’s the harm? A night in a casino can be really fun, and who knows, you may defy the odds and come out ahead. I feel the same way about stock speculation. To stake your financial stability on stock speculation is foolish, however, some people love to pick stocks and hope to beat the odds. As long as you are sizing your bets appropriately in the context of your entire financial picture and future plans, then I say have at it. If you are a person who loves picking stocks, then do it properly by using a strategy that maximizes your already low odds of success. Finally, you should speculate with a clear understanding of just how low your odds of success are in generating the spectacular returns you have been dreaming about.
In this Investing Insight, I am going to show you how an investor could have turned $300,000 into $272,000,000, why you should not try and do that yourself, and if you must speculate in the stock market, how to maximize your already low odds of success.
How to turn $300,000 into $272,000,000
Investors are naturally attracted to outlier investing results. This attraction is similar to when a gambler hits the jackpot on a slot machine causing bells and sirens to go off. All the bystanders believe they too could hit a jackpot and dump their money into the slot machines at an even faster clip. Gamblers and speculators believe that outlier results are more likely to be repeatable than they are in reality. Of course, the odds of the other gamblers in the casino hitting a jackpot have not changed and the odds of winning a jackpot remain terribly low.
Amazon is the investing version of the slot machine. If you had invested $300,000 in Amazon at it’s IPO in 1997, your initial investment would be worth more than $272,000,000 dollars today. That is a cumulative return of 90,613%!
Growth of $300,000 Investment In Amazon (AMZN)
In order to achieve these investing results, you would have had to find an obscure online book seller, then predict they would expand into the largest online retailer in the future as a thing called eCommerce became the primary method of shopping for consumers. Assuming you picked the winner in Amazon, you would have had to hold on to the stock through some jaw dropping losses. For example, in 1999 your initial investment of $300,000 would have already been worth more than $13,184,379. However, over the next few years you would have been required to patiently watch your new fortune dwindle down to $914,241 between March of 1999 and September of 2001. Few people would be able to stand by and watch that amount of money disappear without reacting and selling.
Great fortunes have been created through extreme concentration
I showed you the Amazon example for two reasons, the first is to demonstrate that fortunes can be made in a stock, the second is to show you that making a fortune in a stock is like winning the jackpot or even the lottery. Most often the investors that realize these types of returns are the founders themselves. They have different incentives to hold on to their stock than the average investor and most importantly they are investing in themselves. They have control of the company and are trying to realize their vision, making it much easier to hang on through hard times.
Investors who want to gamble, have a better chance of starting a company with their capital, instead of investing in someone else’s. The greatest fortunes in the world, almost without exception, have been created by founders of highly successful businesses, where their entire net worth was invested in their companies. In other words, great fortunes are created through extreme concentration.
The speculator’s dilemma
Diversification is a great risk management tool for investors, but diversification is the reason why speculators chasing the huge, life changing returns rarely, if ever, succeed. Diversification is mysterious and research clearly shows that when deciding how much diversification you should have, in terms of how many individual stocks you should own, you essentially have two choices if you believe in probabilities. To maximize your odds of investing success you should either have virtually no diversification or nearly total diversification, meaning you need to own nearly all the stocks in the market.
Now, the problem with these two choices is that they are corner solutions and the likely outcomes between virtually no diversification and nearly total diversification could not be more different. I will cut to the chase, since we are talking about how to speculate in stocks with the goal of earning returns at least twice those of the total market, you only have one choice, virtually no diversification. Total diversification will earn you close to the historical average returns of the stock market over the long-run because you own the entire stock market. Because you own the market you are trying to outperform, dramatic out performance that speculators pursue is impossible. Stocks have earned long-run average returns of less than 10% a year. These are good returns but not life changing, like owning just Amazon and generating a 90,000% return since 1997, which is the embodiment of a stock speculator’s dream.
What about a happy medium level of diversification, somewhere between 5 to 60 individual stocks? Most speculators choose this modest level of diversification and do not know they have virtually eliminated their chances of earning very high returns. To demystify diversification, and better understand why moderate diversification is not optimal, we need to get an understanding of the historical distribution of individual stock returns.
Most stocks do not pull their weight
I promise this will be the only statistical jargon I use in this discussion, but it is important to know that the long-term distribution of individual stock returns have historically been positively skewed. Positively skewed means that large positive returns of a few stocks (think Amazon), compensate for the negative returns of the majority of the other stocks. In a great study by Hendrik Bessembinder (2018), he looked at the extent to which the long-term returns of individual stocks are positively skewed, the results are a warning to stock speculators and non-speculators alike.
Bessembinder looked at all the 25,300 companies that issued stock that are recorded in the most comprehensive stock database called the Center for Research in Securities Prices monthly stock database (CRSP), between 1926 and 2016 and found the following:
- Just five stocks (Exxon Mobile, Apple, Microsoft, General Electric and IBM) account for 10% of the total wealth creation between 1926 and 2016.
- Just 90 stocks or one third of a percent of all stocks account for more than half of the total wealth creation between 1926 and 2016.
- The top returning 4% of companies or 1,092 of the 25,300 companies, accounted for 100% of the wealth creation between 1926 and 2016.
- Less than half the stocks listed between 1926 and 2016 generated positive returns.
The bottom line here is that 4% of all stocks have been responsible for 100% of the wealth creation over the long-term, the other 96% of stocks when taken together, just matched the return of one-month treasury bills over the same period. This means the odds of picking, then holding one of the handful of stocks that will produce extremely high returns is very low.
However, your odds of dramatic outperformance become even lower if you moderately diversify your portfolio. When creating a moderately diversified portfolio, assuming you do not get lucky and pick one or more of the handful of stocks that will generate dramatic performance, you have almost no chance of beating the market or generating unusually high returns, because of the high probability you will be holding negative-returning or average-returning stocks in great abundance. It is however worth mentioning that your downside risk will be much lower because of the diversification. If on the other hand, you get lucky and choose one or two of the top performing stocks, moderate diversification will likely materially dilute the positive impact of the high returning stock on the portfolio’s total returns, leading to less than life changing results.
Because only a very small number of stocks have been responsible for the total wealth created in the stock market, by owning a moderately diversified portfolio, you systematically decrease your odds of producing spectacular returns because even if you pick a winner, the weight that stock has in the portfolio may not be significant enough to make up for the much higher probability that you picked many losers.
Moderate diversification is no man’s land
As a result of the positive skew of individual stock returns, you dramatically increase the odds of generating good returns, but not jackpot returns, by opting to hold a nearly fully diversified portfolio of stocks. The positive skew of individual stock returns is so dramatic over the long-term, to generate returns better than one-month treasury bills, it is very important that you hold all or most of the highest returning stocks so they can offset the negative returns of the approximately 50% of stocks in the market that will weigh down the performance.
Since it is impossible to know which stocks will be the big long-term winners, moderate diversification is almost certain to result in poor returns because each added stock is essentially a random guess, and the odds of picking losers or average stocks is so high that you will almost certainly be systematically beaten down by probabilities over time. Even if you get lucky and pick a few winners, the size of the allocation you have to the best performing stocks is not likely to save your portfolio from mediocre results.
The mystery of diversification is really a statistical math problem, the results of the analysis of the distribution of individual stock returns, illustrates that moderate diversification is a no man’s land, and those who wish to speculate are advised to avoid moderate diversification because your chances of success are basically eliminated by probabilities. For those investors who do not wish to speculate but instead simply seek decent returns, no man’s land should also be avoided, and you should accept market or close to market returns my owning a nearly or totally diversified portfolio of stocks.
For the majority of investors who are not speculators, this discussion is very important for you as well. A large percentage of investment advisors and still much of the investment industry focuses on investing in moderately diversified portfolios of stocks for their clients. If your portfolio holds mostly individual stocks or you own mutual funds, you are invested in no man’s land. The most common investment strategy is trying to beat the market through a moderately diversified portfolio of individually selected stocks. I have written in the past about my distaste for mutual funds, it is important that investors understand that the positive skew of individual stocks is why the vast majority of mutual funds do not beat their benchmark and add excessive stock risk to a portfolio, which further inhibits the amount of wealth you are likely to generate from investing over your lifetime.
How to speculate in stocks
If you are one of those investors who just likes picking stocks, I understand that it can be fun to have a horse in the race. Before you start speculating it is wise to first consider a few things. Your top consideration should be the percentage of your investable assets to use for speculation. Depending on your wealth, income, future financial needs and other factors, risking no more than 10% of your investable assets on stock speculation seems reasonable to me. The remaining 90% of your investable assets should be in a risk minimizing, fully diversified portfolio. Also, if you wish to speculate it can be beneficial to also increase your savings rate to compensate for the added investment risk you are taking on.
Next, you will need to decide your strategy for diversification and stock selection. The diversification problem is fairly easy, we have established that moderate diversification is a bad approach and nearly complete diversification does not work for speculation purposes. I would recommend a portfolio of around three stocks. The stocks you select should be in different industries if possible.
There is no “right” way to pick the individual stocks you select. However, I would recommend linking your fortune to companies that have a founder you respect who is running the company. Ideally, the founder/CEO would also have most of their net worth invested in the company making their fortunes tied to the success of the business. While more established companies may have more limited upside, compared to new companies. I would not shy away from investing in established companies, especially if you think their market position is ideal and the CEO plans to capitalize on market opportunities you see for the business.
It is my opinion that your stock selection choices should be based primarily on your own fundamental analysis of a company, including its management, the competitive advantages and barriers to entry it has in its favor, and finally your expectations for the industry in which the company operates. When trying to pick the big winners, I believe scrutinizing financial statements does little to help you find an opportunity and understand a company’s future potential. Amazon, lost money for two decades and just recently began generating very small profits, you would not have picked Amazon based on their financials in 1997.
You can also improve your odds of success in stock picking by investing in industries and companies where you have expertise and strong personal interest. Having a deep understanding of a specific industry, the companies within the industry and their positioning is a huge advantage. Just keep in mind there is no wrong way to guess the future, so use any information or process that you think gives you the highest probability of success.
Finally, you should plan to hold each stock for at least five years, as stocks with the greatest growth potential can be very risky and so you need to be able to stand by and accept possibly large losses during your investing horizon. I always recommend you put in some selling rules that will help you not react to shorter-term stock movements. The rules should probably be tied to management or significant changes within the companies you think change your investing thesis. Rules are only good if you follow them, so make sure to commit to following your own rules. Also, to prevent yourself from making poor decisions, keep in mind that you knowingly invested in a very risky strategy with a low probability of success and making many short-term changes to your portfolio will make success less likely, not more.
Good luck and speculate responsibly.
References:
Bessembinder, Hendrik (Hank), Do Stocks Outperform Treasury Bills? (May 28, 2018). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2900447 or http://dx.doi.org/10.2139/ssrn.2900447
Additional Resources
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