A Stock vs. An Index

According to Jason Zweig, in the year following the market bottom on March 23, 2020, 96% of U.S. stocks had positive returns. That was the highest percentage over any 12-month period in history. Seemingly everyone was getting rich investing in stocks, crypto, SPACs, IPOs, collectibles, NFTs, etc.

Remember when we were bombarded with headlines like this:

The problem with these types of stories is you never hear the other side of them—the people who got in at the top and lost it all. Almost a year ago I explained how money made with ease is often lost just as quickly.

Well, those headlines seem like a distant memory now due to the losses that have occurred in the markets this year. Crypto has gotten crushed, erasing more than $1 trillion of wealth over the past handful of months. NFT sales plummeted 92% from their peak. And hyper-growth tech stocks are down anywhere from 25% to 40%.

With many popular stocks experiencing fairly significant losses, I’ve started to hear things like, “Now is the time to get in!” and “I should buy more shares since the stock is on sale, right?”

So I wanted to briefly explain why buying an individual stock when it’s down is not the same as buying an index (a basket of stocks that represents a segment of the market) when it’s down. This may be obvious to some, but I think it’s important for investors to understand.

To start, there is absolutely no guarantee that an individual stock will ever recover from its losses.

Just because one of your favorite companies is down 20% does not mean it’s a great buying opportunity. Netflix is down around 70% from its high and it may never get back. In fact, that scenario is quite common. More than 40% of stocks in the U.S. since 1980 fell 70% from their peak and never reached those levels again.

However, that’s unlikely to occur with an index fund. Why? Because an index fund is always changing. When you buy an index like the S&P 500, you don’t hold the same 500 stocks for 30 years. Due to economic and technological development, new companies are brought into the index, and old companies are kicked out.

Of the 28,853 companies that traded on U.S. markets since 1950, 78% of them had died by 2009. Historical research suggests that roughly half of all public U.S. companies in existence today won’t be in existence a decade from now. They will either merge, be acquired, go bankrupt, or find some other way out of the market.

Interestingly enough, the longevity of a company in the S&P 500 has been on a gradual decline. In 1965 the average time spent by a company in the index was 33 years, but today it’s closer to 20 years. Companies are being replaced at a faster rate than in the past.

Index funds add the biggest gainers and drop the biggest losers over time. By doing so, they also offer better returns than individual stocks. In Nick Maggiulli's new book, Just Keep Buying, he shares:

“If you look at the universe of individual stocks in the U.S. going back to 1963, the median one-year return is 6.6%, including dividends. This means that if you grabbed an individual stock at random at any point in time since 1963, you would’ve earned roughly 6.6% over the next year. However, if you did the same thing with the S&P 500, you would’ve earned 9.9% instead.”

To conclude, tread carefully when you’re contemplating buying an individual stock that’s down big. Nearly any individual stock could drop 80% to 100% and the world wouldn’t fundamentally change. You would still have bills to pay the next day and the world would move on.

However, if an index like the S&P 500 went to zero, life as you know it would come to a halt.

That’s the benefit of diversification.

Thanks for reading!