The lesson of Facebook: Picking stocks is hard

(MoneyWatch) The desultory post-IPO performance of Facebook's (FB) stock provides a good opportunity to learn about the basic principles of prudent investing. Among the most basic tenet is that it's very difficult to outperform the stock market on a risk-adjusted basis through the art of picking stocks.

Ron Lieber's recent New York Times column provided a great example of just how difficult it is to beat the market. He asked Wilshire Associates to look back 30 years to the beginning of the bull run in stocks and figure out which of the companies in its index of more than 5,000 American businesses had performed best over that stretch. One surprise: Most investors are unlikely to have heard of five of the 10 best performers (I know I hadn't): Here they are:

• Danaher (DHR, #3 on the list)
  
• Apco Oil & Gas (APAGF, #4)
• Precision Castparts (PCP, #7)
• Raven Industries (RAVN, #8)
  
• HollyFrontier (HFC, #10)

And the No. 1 performer wasn't some high-tech or biotech firm, but rather Home Depot (HD)! The top 10 stocks earned annualized returns of 21-26 percent. To earn those returns, you would've had to find those needles in the market haystack and had the discipline and courage to hold on for 30 years. Good luck.

The following is another great example of the folly of trying to pick individual stocks. Can you name the stock that for the 20-year period ending in 2006 outperformed Berkshire Hathaway (BRK) by an astounding 4.5 percent a year? It's none other Bear Stearns! Consider a story about the investment bank, which foundered following the housing crash and was acquired by JPMorgan Chase (JPM) in 2008, appeared in Barron's in 2004. The author noted that "with the company's low-risk profile and strong controls, investors in Bear Stearns can sleep well, knowing that even a full-blown financial crisis is unlikely to cripple the firm."

In January 2007, the stock hit an all-time high of $171. We can only wonder how many Bear Stearns employees had significant portions of their net worth tied up in company stock because they "knew" what a great company it was. And surely they would know if there were problems arising and have sufficient time to exit. It's also safe to assume that those same employees wouldn't have invested in Bear Stearns stock if they were employed elsewhere. Bear Stearns was not any safer because the individuals happened to work there. And for senior management, they may even have an illusion of the ability to control events.

In other words, the prudent strategy is to diversify all of your assets, including your labor capital. And while the surest way to get rich is to concentrate your assets, it is also the surest way to go broke. While investors who had concentrated positions in Bear Stearns suffered greatly, investors who owned market-like global portfolios had a small fraction of 1 percent of their assets in Bear Stearns stock, even when it traded at its peak. This is a clear demonstration of the importance of diversifying stock risks. Unfortunately, as sure as death and taxes, despite the lesson Bear Stearns provided, this same mistake will be repeated many times over by future investors.

There's an overwhelming body of evidence that demonstrates that persistently beating the market on a risk-adjusted basis is extremely hard to do. This holds true for individual investors, mutual funds, pension plans, and especially hedge funds. In fact, there's no evidence that any outperformance is more than a random outcome.

The following is one of my favorites on just how difficult it is to persistently pick winning stocks. The 1990s witnessed one of the greatest bull markets of all time. Yet 22 percent of the 2,397 U.S. stocks in existence throughout the decade had negative returns. Not negative real returns, but negative absolute returns. Even this shocking figure is inaccurately low. The reason is that it includes only stocks that were in existence throughout the decade -- there's "survivorship bias" in the data.

Stocks are much riskier than investors believe. The reason is that stock returns aren't normally distributed -- the dispersion of individual stock returns doesn't resemble a bell curve where the median return is the same as the mean return. If the dispersion of individual stock returns resembled the bell curve, the returns of half the stocks would be above the mean and half would fall below the mean. However, this isn't the case because while your profits are unlimited, you can only lose 100 percent.

Thus, a few big winners cause the average return to be above the median return. As a result, there are more stocks that have below-"average" returns than there are stocks with above-average returns. Along with the high efficiency of the markets in processing information, this makes the purchase of individual stocks a loser's game. Let's take a deeper look at why this is the case, beginning with the risks investing in stocks entails.

Stock investors face several types of risk. First, there's the idiosyncratic risk of investing in stocks. Second, various asset classes carry different levels of risks. Small-cap stocks are riskier than large-caps, and value stocks are riskier than growth stocks. These two risks -- size and value -- can't be diversified away. Thus, investors must be compensated for taking them. The third type of stock risk is that of the individual company.

The risks of individual stock ownership can easily be diversified away by owning passive asset class or index funds that basically own all the stocks in an entire asset class or index. Each of these vehicles eliminates the single-company risk in a low-cost and relatively tax-efficient manner. Note that asset-class risk can also be addressed by the building of a globally diversified portfolio, allocating funds across the various asset classes of domestic and international, large and small, value and growth, real estate, and emerging markets.

The benefits of diversification are obvious and well-known. Diversification reduces the risk of underperformance. It also reduces the volatility and dispersion of returns without reducing expected returns. Thus, a diversified portfolio is considered to be more efficient than a concentrated portfolio. The problem is that most investors fail to diversify. This failure has its roots in two distinctly different sources: lack of knowledge and human behavioral traits.

Because most investors haven't studied financial economics, read financial economic journals or read books on modern portfolio theory, they don't have an understanding of how many stocks (hundreds, if not thousands) are really needed to build a truly diversified portfolio. Similarly, they don't have an understanding of the nature of how markets and stocks behave in terms of risks and rewards (the issue of compensated versus uncompensated risk). The result of the lack of knowledge is that most investors hold portfolios with assets concentrated in relatively few holdings.

Investors also fail to diversify because they make behavioral mistakes. Among the most common are:

• Overconfidence: Even when individuals know that it's hard to beat the market, they're confident that they will be among the few who succeed.
• Confuse the familiar with the safe: They believe that because they're familiar with a company, it must be a safer investment than one with which they're unfamiliar. Being familiar with a company creates the illusion that the information they have is "value relevant" -- not already incorporated into prices.
• Believe that by limiting the number of stocks they hold, they can manage their risks better: It's just an illusion, another form of overconfidence.
• Owing individual stocks provides a false sense of control over the outcomes by being involved in the process of stock selection. It's the portfolio's asset allocation that matters, not who's controlling the switch.

Investors are rewarded with higher expected returns for taking systematic risks, risks which can't be diversified away. With equities there are three types of risk:

• Beta (exposure to the overall stock market)
• Size (exposure to small-cap stocks)
• Value (exposure to stocks with high book-to-market or low P/E ratios)

The academic research makes clear that the majority of a portfolio's returns are determined by its exposure to these risk factors, not stock selection. That makes individual stock selection a loser's game.

If you happen to own Facebook, having bought it at the IPO expecting an immediate profit, here is my advice: If you had cash instead of the value of your Facebook shares, if you wouldn't use the cash to buy Facebook shares today (with the knowledge you now have), you should sell. The reason is that every day you hold it's the same thing as making the decision to buy. And at least you will have the benefit of Uncle Sam sharing in your loss.

Image courtesy of Flickr user Dru Bloomfield - At Home in Scottsdale