Whether it’s missing out on the gains of Nvidia or feeling late to the stock market after years of strong returns, being left out can feel unsettling. The good news is that unlike a sale that ends at midnight, investing in the market doesn’t come with a fixed deadline. For many people, once the decision to invest is made, two questions quickly follow: How do I invest? and What exactly should I invest in?
Both questions are a good starting point when meeting with a financial advisor. The second, however, opens an important conversation about what markets have taught us over the years and how investors are rewarded for the risks they take.
Understanding the Risks for Investors
Think about investing as owning farmland. Over time, farmland can be very productive, but each growing season comes with uncertainty. Uncontrollable weather patterns like droughts, floods, or unusually cold winters affect almost everyone at once. In investing, this is similar to market risk — economic forces that impact nearly all companies at the same time.
However, unpredictable weather is not the only risk to crop output. Individual farms face their own challenges. For instance, a single field might suffer from poor soil, pests, or an unexpected disease, even when neighboring farms do just fine. This is similar stock specific risk — problems tied to one company rather than the broader market. To put this into perspective, a poorly performing year for an individual U.S. stock tends to fall about 29.4%, compared with just a 7% decrease for the broader U.S. stock market (S&P 500). This difference highlights the risk of investing in individual stocks that translates to a 22-percentage point gap.
Why Picking Stocks is Harder Than it Appears
Aside from market and stock-specific risk, there are psychological biases that can further hinder investment performance. Investors with limited experience often underestimate the difficulty of stock picking especially after a few good calls or a compelling story that creates the impression that skill alone can overcome uncertainty — often referred to as overconfidence trap. Lower perceived risk often leads investors to focus on selecting just a few “promising” stocks, believing that with enough research and insight from professionals, they can consistently make the right picks. This prominent bias usually leads investors with investment returns that underperform the broad market over time.
Even professional investors equipped with vast research and abundant resources have difficulty picking winning stocks. The S&P Indices Versus Active (SPIVA) scorecard highlights that 93% of the professional stock pickers invested in US companies underperformed the broader US stock market in the last 15 years. Just like many retail investors, even professional investors will point to a good year or two, but very few consistently pick the right “crops” season after season.
Well, why is that? Research by Professor Hendrik Bessembinder, which examined decades of stock returns, found that an average stock underperformed one-month US Treasury bills, essentially cash. Bessembinder points out that about 2.4% of the stocks account for $75 trillion in global stock market gains from 1990 to 2020. The excessive coverage received by these exceptional stocks in conversations, media, and other parts of our lives creates the illusion that these extraordinary winners are also abundant.
How Asset Allocation Can Assist In Constructing a Portfolio
This is where asset allocation plays a critical role. By spreading investments across asset classes, sectors, geographies, and thousands of individual companies, asset allocation dramatically reduces stock specific risk. How dramatic is the effect? Research shows that the variance of investment returns typically drop by more than 50% when the number of stocks in a portfolio increases from one to five and continues to decline as additional stocks are added. The key takeaway is that exposure to a large number of stocks across different sectors and industries effectively minimizes stock-specific risk. In other words, when one company struggles, its impact on the overall portfolio is limited. Practitioners often refer to this phenomenon as the diversification effect.
We must caution that asset allocation doesn’t eliminate risk. Market downturns are unavoidable and the goal is not to avoid bad seasons altogether, but to build a portfolio resilient enough to endure them and continue growing over time. Long-term success is anchored to investing in a diversified portfolio and staying invested through market downturns, allowing time and economic growth to do the heavy lifting.
