Retail stock pickers should receive mandatory risk warnings
This year, markets are placing risk in the “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 problem: risk is the cost of potentially higher gains. Some investors take on more risk than others. If you’re facing bigger losses than you can afford and you’re not getting a higher overall return, rethink your investment strategy. As volatility returns and the era of memestocks comes to an end, it’s worth asking: Should retail investors even be allowed to own individual stocks?
This may seem extreme. After all, what epitomizes capitalism better than buying a piece of a company you admire, respect, or just think will make you rich? Except that we put safeguards in place when it comes to other aspects of our lives, from data protection to buying a mattress. Yet risk taking, the essence of individual stock investing, is not only unlimited, it is often encouraged.
Let us distinguish between owning shares and owning shares in particular corporations. We should encourage share ownership. Portfolio risk is often the only way to grow wealth. But there is a good way to take risks and a not so good one.
Between the rise of online trading platforms and [retirement plans], more people own stocks than ever before, but we never bothered to educate people on the basics. When you invest in the stock market, you face two types of risk: idiosyncratic, or the risk that a single stock will fall; and systematic, the risk that the whole market will go down. There is not much you can do about this last risk except 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 make up for a stock’s losses. 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 with hundreds or thousands of stocks. This partly explains why index funds tend to outperform hand-picked stock portfolios.
During America’s memestock frenzy, it was surreal to see consumer welfare advocate Senator Elizabeth Warren arguing that the problem wasn’t small day traders, it was big investor behavior that needed to be curbed. to make market speculation fair for all. But whatever regulators do, stock market speculation is rarely good for retail investors. Especially when betting against institutional investors, who often just have a natural advantage due to their much bigger pockets, time and arguably greater skills.
While there are good reasons not to own individual stocks, there is a social benefit to this practice. Ownership connects people to companies, educates investors about the markets, and gets people thinking about how they work, which can help them feel better about capitalism, which is important in these times.
Ideally, retail investors should treat stock picking as a hobby, not an investment, and devote only a small portion of their portfolio to individual stocks. Just as you don’t go to the casino as an investment strategy, but for certain entertainment, so should buying specific stocks.
And yet, from seatbelts to vaccinations, governments can’t always rely on citizens to do what’s in their own best interests. They need a little help. For argument’s sake, here are a few options:
First, let only accredited investors, high net worth individuals and hedge funds buy individual stocks. This is how it already works for private assets. The system needs someone to buy and sell individual stocks for price discovery and to maintain market efficiency, but eligible investors might be limited to those best suited for this role. While that might be okay in a world of pure financial theory, it’s probably not good for society.
Second, it is harder to own individual stocks. Buying stocks is incredibly easy. Unlike pension plans, which warn us of the consequences of a withdrawal, no such warning is sent before we take inventory action. Perhaps we should at the very least be forced to take similar steps, with similar precautions, to buy individual stocks. This may not make a difference to most buyers, but it at least tries to educate people that investing in individual stocks comes with additional risk and shouldn’t be the norm.
Three, keep doing what we’re doing. Facilitate individual trading on different platforms and let a growing number of people bear inefficient risk. Some people will suffer financially, but that’s life.
The last option is the most likely. But the second would be best. I am normally skeptical of clumsy regulation and think [people] need more risk in their lives to thrive. But if regulation is supposed to do anything, it’s to incentivize people to take better risks while preserving as much choice as possible.
Allison Schrager is a columnist at Bloomberg Opinion, 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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