Because stocks are close to being priced perfectly, on average you will do about as well as the market does.
I think that’s right, but the downside is that your portfolio will have greater volatility/risk for the same average performance, so you’ll no longer be on the efficient frontier. However I don’t have a good intuition about how costly this actually is in practice, if you only play with 10% of your portfolio.
If you have private information or insights that the market hasn’t priced in (i.e. the efficient market hypothesis isn’t completely true), you could beat an index fund.
I think the problem with this argument is that yes you can beat an index fund if you have private information or insights, but you also need to be no more biased than the people you’re trading against, but they may actually be a lot less biased than you are, at least as far as stock trading is concerned, because they’re professionals (hence selected for having less bias) and they’ve had a lot more chances to practice.
(I personally bought some individual stocks when I was younger for reasons similar to ones you list, but they mostly underperformed the market so I stopped.)
I don’t have a good intuition about how costly this actually is in practice, if you only play with 10% of your portfolio.
tl;dr extremely little.
Here’s some numbers I made up:
Let the market’s single common factor explain 90% of the variance of each stock.
Let the remaining 10%s be idiosyncratic and independent.
Let stocks have equal volatility (and let all risk be described by volatility).
Now compare a portfolio that’s $100 of each of a hundred stocks with one that’s $90 of each of a hundred plus $1k of another stock. (I’ll model each stock as 0.75 times the market factor plus 0.25 a same-variance idiosyncratic factor.) Compared to a $10k single-stock portfolio...
the equal-weighted portfolio has σ like √(75∗100)2+252∗100√75002+25002≈0.9492
the shot-caller’s portfolio has σ like √(81∗100+900)2+22.52∗100+2502√75002+25002=0.9496
...for an increase in σ of 4.5 basis points. So, pretty negligible.
Even if the market’s single factor explains only half of the variance of each stock, the increased risk of the shot-caller’s portfolio is just 40 basis points (0.7135 vs 0.7106). In the extreme case where stocks are uncorrelated, the increased risk is +34.5%, though I think that that’s unrealistically generous to the diversification strategy.
Since an increase in volatility-per-dollar of x basis points means that you give up x basis points of your expected returns, I’m going to say that this effect is negligible in the “10% of portfolio” setting.
I think that’s right, but the downside is that your portfolio will have greater volatility/risk for the same average performance, so you’ll no longer be on the efficient frontier. However I don’t have a good intuition about how costly this actually is in practice, if you only play with 10% of your portfolio.
I think the problem with this argument is that yes you can beat an index fund if you have private information or insights, but you also need to be no more biased than the people you’re trading against, but they may actually be a lot less biased than you are, at least as far as stock trading is concerned, because they’re professionals (hence selected for having less bias) and they’ve had a lot more chances to practice.
(I personally bought some individual stocks when I was younger for reasons similar to ones you list, but they mostly underperformed the market so I stopped.)
tl;dr extremely little.
Here’s some numbers I made up:
Let the market’s single common factor explain 90% of the variance of each stock.
Let the remaining 10%s be idiosyncratic and independent.
Let stocks have equal volatility (and let all risk be described by volatility).
Now compare a portfolio that’s $100 of each of a hundred stocks with one that’s $90 of each of a hundred plus $1k of another stock. (I’ll model each stock as 0.75 times the market factor plus 0.25 a same-variance idiosyncratic factor.) Compared to a $10k single-stock portfolio...
the equal-weighted portfolio has σ like √(75∗100)2+252∗100√75002+25002≈0.9492
the shot-caller’s portfolio has σ like √(81∗100+900)2+22.52∗100+2502√75002+25002=0.9496
...for an increase in σ of 4.5 basis points. So, pretty negligible.
Even if the market’s single factor explains only half of the variance of each stock, the increased risk of the shot-caller’s portfolio is just 40 basis points (0.7135 vs 0.7106). In the extreme case where stocks are uncorrelated, the increased risk is +34.5%, though I think that that’s unrealistically generous to the diversification strategy.
Since an increase in volatility-per-dollar of x basis points means that you give up x basis points of your expected returns, I’m going to say that this effect is negligible in the “10% of portfolio” setting.