Stock Picking Shouldn’t Be Allowed for Everyone

“Markets this year are putting the risk in risk premium. Any asset that typically pays more than a low-risk bond (or zero return) will expose you to losses from time to time, and that happened a lot last month. But that’s the deal: Risk is the cost of potentially higher gains. Some investors take more risk than others. If you face bigger losses than you can afford and don’t get an overall higher return out of it, you need to rethink your investing strategy. And if that describes you, then odds are you own individual stocks. As volatility comes back and the Memestock era ends, it's worth asking: Should retail investors even be allowed to own individual stocks?

That may sound extreme. After all, what embodies American capitalism better than buying a piece of a business you admire, or respect, or just think will make you rich? Except we set up guardrails and warnings when it comes to many other aspects of our lives, from data protection to buying a mattress. Yet taking on more risk than necessary, which is the essence of individual stock investments, is not only unrestricted, it's sometimes cheered on.

There's an important distinction here between owning stocks and owning shares in particular companies. We should encourage stock ownership, and I believe Americans should be taking more risk. Risk in your portfolio is, for most of us, the only way to grow wealth. Only about 50% of Americans own stock and this contributes to wealth inequality. But there is a good way to take risk and a not-so-good way. The economist who taught me finance often says owning an individual stock is like owning a car muffler. Its value comes from its role as part of a larger system, which in finance translates to a good diversification strategy.

Between the rise of online trading platforms and workplace 401(k)s, more Americans own stock than ever before, yet we never bothered to educate people on some of the basics. When you invest in the stock market you face two kinds of risk: idiosyncratic — the risk a single stock will rise or fall; and systematic — the risk the whole market will rise or fall.

There's not much you can do about systematic risk other than reduce your exposure and give up some potential returns. But idiosyncratic risk is totally avoidable, you just need to buy lots and lots of other stocks that offset losses when one stock is down. If you diversify properly, you get the only free lunch in finance: higher expected returns and less risk. And it turns out the cheapest and easiest way to get that perfect diversification is to buy an index fund that contains hundreds or thousands of stocks. This explains, in part, why index funds tend to outperform hand-picked stock portfolios.

During the Memestock frenzy it was surreal to see consumer welfare advocate Senator Elizabeth Warren argue that the problem wasn't small day traders, it was the behavior of big investors that needed to be reined in to make market speculation fair for all. But no matter what regulators do, stock speculation is rarely good for retail investors. Especially when they're betting against institutional investors, who — rather than playing dirty — often just have a natural advantage because of their far deeper pockets, time, and (arguably) greater skill.

While there's a good economic case against owning individual stocks, the practice does have a social benefit. Share ownership connects people to public corporations. It teaches investors about markets, makes people more engaged with how they work, and that may make them feel better about capitalism, which is important these days. Our economy and culture is based on the idea that anyone can take a risk, even an ill-advised one, and get rich.

Ideally, retail investors should view stock picking as a hobby, not as investing, and only dedicate a small share of their portfolio to individual stocks. Hopefully you don’t go to a casino as an investment strategy; It's entertainment. The same should be true for buying shares in individual companies. And yet, from seat belts to vaccinations, governments can't always count on their citizens to do what's in their own best interest — sometimes they need a little help. For argument's sake, here are some options:

  1. Only allow accredited investors, people with a high net worth and hedge funds to buy individual stocks, which is basically how it already works for purchasing private assets. The system needs someone to buy and short individual stocks for price discovery and to keep the market efficient, but eligible investors could be narrowed to those who are best positioned for this role. Though this may be correct in a world of pure financial theory, it's probably not good for society.

  2. Make owning individual stocks just a little harder than it is now. To research this column, I bought my very first individual stock ($10 bought me two shares) through my brokerage account and it was shockingly easy. It was harder to opt out of the expensive default option in my workplace 401(k) plan. When I did that, I was subjected to lots of warnings that my low-cost index fund (same investment mix as the default — just cheaper) could undermine my retirement goals. There was no such warning when I bought that single stock. Perhaps at the very least we should be forced to jump through similar hoops, with similar cautions, to purchase an individual stock. This may not make a difference for most buyers, but it at least it tries to educate people that individual stock investing carries extra risks and shouldn't be the norm.

  3. Keep doing what we are doing. Make individual trading easier on the various platforms and let a growing number of people bear inefficient risks. Some people will get burned, but that's life.

The last option is the most likely. But the second one would be best. I'm normally skeptical of clunky regulation and think Americans need more risk in their lives to prosper. But if regulation is meant to do anything, it's to steer us to take better risks, while preserving as much choice as possible.”


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