Many beginners ask for help in picking their investments, and I often see many responses of people either saying index funds or “safe” stocks like blue chip or large American companies. This is a reminder that just because a company has a large market cap, does NOT make it a safe investment. With a lot of talk on margin and other potentially dangerous investing practices; remind yourself that an individual business will always be riskier than an index fund, regardless of what the business is. Index funds are designed to be a collection of companies so that you mitigate idiosyncratic risk within single picks. This means you don’t have as much risk of losing much more than anticipated versus a single company. This way when you hold the basket of stocks, each company losing or gaining will have a smaller effect on the portfolio (depending on weighting). Now, the issue is that many people think when a company becomes larger you get a safer pick. This is somewhat true, it’s much less likely for McDonalds to fail than it is for some random micro cap biopharma. They also will be less volatile for daily swings, HOWEVER, you must understand that even with the largest companies, there is significantly more risk than buying an index even for large market caps. A common term for a while was that many “blue chip” companies are safe options for investors, these are large companies that are often recognizable brands. These businesses are usually a larger market cap, but this is where you can’t be mistaken: you are taking in significant risk EVEN with a large company. For example, the picture shows the recent events surrounding $UNH with the assassination of the CEO. The value of the company has collapsed over 40% in 1 year, and basically gone equal in 5 years. United Health at the time had a market cap of over $400 billion, meaning it was one of the largest companies in the planet. To many it may have seemed like a safe large cap opportunity, but this became not the case in less than a year. It lost most of its value and put investors deep in the red had they bought anytime in the last 3 years. This does not happen in an index, hence you don’t have idiosyncratic risk. Now, there’s an argument to be made that healthcare was the forefront of cultural shift, and yet the financials and the business said otherwise: until it didn’t. Massive changes like this happen completely outside of your control, and it’s the risk you take by investing inside single businesses. Now, this isn’t an argument for or against single stock picks, but rather education. The majority of investors however do not do anywhere near as much research as they should be. Remember that anyone telling you to buy something other than a well diversified index as a beginner should be researched or ignored rather than blindly buying. As always, do your research and happy investing!
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15 Comments
Mr Financial
@mr.financial · 1yr
Wise beyond your years ronan. To add for clarity, Idiosyncratic risk is always there for single stocks. You can't research ('be in the know') your way out of it. It's much the same as systematic risk that broad market index ETFs are exposed to. Single stocks have systematic AND idiosyncratic risk.
Jacob B
@jacobb · 1yrEdited
I agree, but also; price movements don’t correlate with value or quality
Brett
@birdmanbrett · 1yr
Exactly why I don’t like market cap weighted etfs.
Mahyar
@4mula4 · 1yrEdited
Great points! But here’s another view. Index funds are safe and smart for most people, but picking strong companies can still work if you do your homework. Big companies can drop, but they can also grow faster than the whole market. A mix of index funds and a few good stocks might give better returns and still keep risk low. Just we need to be careful and always research/learn before we invest. 🤨
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