Markets this year are putting the risk in ‘risk premium’. Any asset that typically pays more than a low-risk (or zero return) bond will expose you to losses from time to time. 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, rethink your investing strategy. As volatility returns 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 capitalism better than buying a piece of a business you admire, respect, or just think will make you rich? Except we set up guardrails when it comes to other aspects of our lives, from data protection to buying a mattress. Yet, taking on risk, the essence of individual-stock investments, is not only unrestricted, it’s often cheered on.
Let’s distinguish between owning stocks and owning shares in particular companies. We should encourage stock ownership. Portfolio risk is often the only way to grow wealth. But there is a good way to take risk and a not-so-good way.
Between the rise of online trading platforms and [retirement plans], more people own stock than ever before, yet we never bothered to educate people on the basics. When you invest in the stock market, you face two kinds of risk: idiosyncratic, or the risk a single stock will fall; and systematic, the risk the whole market will drop. There’s not much you can do about the latter risk other than reduce your exposure and give up some potential returns. But idiosyncratic risk is avoidable; you just need to buy lots and lots of other stocks that offset losses in one stock. If you diversify properly, you get the only free lunch in finance: higher expected returns and less risk. And the cheapest and easiest way to get that perfect diversification is to buy an index fund that contains hundreds or thousands of stocks. This partly explains why index funds tend to outperform hand-picked stock portfolios.
During the US 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 behaviour 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 often just have a natural advantage because of their far deeper pockets, time and arguably greater skill.
While there’s a good case against owning individual stocks, the practice does have a social benefit. Share ownership connects people to corporations, teaches investors about markets and makes people think about how they work, and that may make them feel better about capitalism, which is important in these times.
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. Just as you don’t go to a casino as an investment strategy, but for some entertainment, the same should hold for buying specific shares.
And yet, from seat belts to vaccinations, governments can’t always count on citizens to do what’s in their own best interest. They need a little help. For argument’s sake, here are some options:
One, only let accredited investors, people with a high net worth and hedge funds, to buy individual stocks. This is how it already works for 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 placed for this role. Though this may be correct in a world of pure financial theory, it’s probably not good for society.
Two, make owning individual stocks harder. Buying shares is shockingly easy. Unlike retirement plans, which warn us of the consequences of opting out, no such warnings are served before we take stock action. Perhaps at the very least, we should be forced to jump through similar hoops, with similar cautions, to buy individual stocks. 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.
Three, keep doing what we are doing. Make individual trading easier on various platforms and let a growing number of people bear inefficient risks. Some people will suffer financially, but then that’s life.
The last option is the most likely. But the second one would be best. I am normally sceptical of clunky regulation and think [people] need more risk in their lives to prosper. But if regulation is meant to do anything, it is to steer people towards taking better risks while preserving as much choice as possible.
Allison Schrager is a Bloomberg Opinion columnist, a senior fellow at the Manhattan Institute and author of ‘An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk’
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