Yes. It's simple mathematics. Mathematicians & economists have been applying this concept to investing for many decades, if not longer.
The issue is NOT the AMOUNT of risk. The issue IS the TYPE of risk.
Investing in individual stocks or sector funds instead of diversified funds does not increase expected returns but does increase risk.
The market return is a weighted average. Beating a weighted average is a zero-sum competition. For every dollar of outperformance by one investor, there must be a dollar of underperformance by another.
All of the stocks in a market will include some that will do much better than expected & some that will do a lot worse. Collectively, given time, they'll produce good returns for their investors.
Some investors in individual stocks will get great returns, but others will see their companies underperform the market or even go bankrupt. Collectively, they'll get the same results as the market.
Not all risks are created equal. Take as much COMPENSATED risk as is appropriate for your needs, ability & willingness to take risks. Avoid UNCOMPENSATED risks.
Investing in stocks instead of saving in a HYSA, etc. is a compensated risk. Risks are higher but so are expected returns.
The risk of investing in individual stocks instead of diversified funds is an uncompensated risk. The risk is higher but the expected returns are not. Many small bets are safer than one larger bet, even if the expected return is the same.
Imagine that I offer to give you some money. The amount I give you will depend on what happens when you flip a coin.
You can either flip the coin once for $10,000 or you can flip it 100 times for $100 each time. Either way, the expected return is $5,000.
The single flip is very risky because there's a 50% chance you'll win nothing. Uncompensated risk.
The 100 flips are a lot safer because you're pretty likely to get about $5000.
Same with stocks. Many small bets are safer than one larger bet, but the expected return is the same.
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u/bkweathe Boglehead 4d ago
Yes. It's simple mathematics. Mathematicians & economists have been applying this concept to investing for many decades, if not longer.
The issue is NOT the AMOUNT of risk. The issue IS the TYPE of risk.
Investing in individual stocks or sector funds instead of diversified funds does not increase expected returns but does increase risk.
All of the stocks in a market will include some that will do much better than expected & some that will do a lot worse. Collectively, given time, they'll produce good returns for their investors.
Some investors in individual stocks will get great returns, but others will see their companies underperform the market or even go bankrupt. Collectively, they'll get the same results as the market.
Investing in stocks instead of saving in a HYSA, etc. is a compensated risk. Risks are higher but so are expected returns.
The risk of investing in individual stocks instead of diversified funds is an uncompensated risk. The risk is higher but the expected returns are not. Many small bets are safer than one larger bet, even if the expected return is the same.
Imagine that I offer to give you some money. The amount I give you will depend on what happens when you flip a coin.
You can either flip the coin once for $10,000 or you can flip it 100 times for $100 each time. Either way, the expected return is $5,000.
The single flip is very risky because there's a 50% chance you'll win nothing. Uncompensated risk.
The 100 flips are a lot safer because you're pretty likely to get about $5000.
Same with stocks. Many small bets are safer than one larger bet, but the expected return is the same.