The Winner's Trap

The Winner's Trap

February 16, 2023

I don’t own any individual stocks. I never have. This surprises people. But you’re in the stock market business.

Yes, that’s precisely why I don’t own any individual stocks. When you pick individual stocks, you lose if the stock performs poorly. That’s obvious. Less obvious is how stacked the odds are against you. A paper was published in the Journal of Financial Economics in 2017. The researcher examined the returns of 26,000 stocks – all common stocks listed on major US exchanges since 1926. That’s a lot of stocks. 52% of stocks only ever lost money. Pick a stock at random, and it’s essentially a coin flip whether you’ll avoid simply losing money. But people don’t buy stocks to avoid losing money. They’re trying to make money. Unfortunately, of the 26,000 companies, only 1,000 accounted for all the gains in the stock market since 1926. In percentage terms, 4% of stocks are responsible for 100% of the market’s gains. And a mere 86 stocks are responsible for ½ of the market’s gains. Again, in percentage terms. 0.33% of companies have been responsible for 50% of the gains in the stock market since 1926.[i]

Are you sure you can pick the winners in the face of those odds? I happily admit I cannot.

Worst case scenario in the stock picking game is you lose everything. A company’s stock can go to zero. It has happened before (many times). It will happen again. It is the nature of our free-market economy that new businesses cannibalize old ones. The rise of the iPhone was great for investors in Apple. It was terrible for investors in Kodak, a blue-chip powerhouse which declared bankruptcy a few years after the first iPhone was released. Creative destruction cuts both ways.

But I want to focus on the best-case scenario. You beat the odds and buy a stock that delivers. One of the 0.33% that drives 50% of the market’s gains. Congratulations. Now what?

Now you’re in the Winner’s Trap.

Your outsized returns are on paper. The gains are “unrealized” as they say in the finance business. But you can’t buy anything with the unrealized gains in your stock portfolio. You can wave your account statement showing all those beautiful unrealized gains in the face of the finance manager at the Porsche dealership all you want; he is not going to let you walk out the door with the keys to a 911 until he seems some cold, hard cash. You are going to have to sell some of your stock. You must “realize” some of those investment gains (or all your gains, depending on the model Porsche).

The Winner’s Trap is a paradox. The better your returns in the stock you bought – the more money you make – the more difficult it is to sell. To cash in and do something with your newfound wealth. It sounds so easy in theory. Of course I would sell after I 10x’d my money! It is not so easy in practice. Selling the asset that has made you rich is one of the most difficult financial decisions you can make. A quick story…

I met someone in 2021 who bought Netflix stock five years previously. During the five-year period ending November 1st of 2021, the stock market (measured by the S&P 500 index) went on a tear: 19.12% annualized returns.[ii] But his Netflix position more than doubled the S&P 500’s return – 40.73% annualized.[iii] 40.73% annualized! That is not something that happens very often. I do not know how much he originally invested, but I know it was substantial. Let’s assume it was $250K. Here is what that would have grown to in Netflix stock vs. the S&P 500:

  • Netflix stock: $1,381,000
  • S&P 500: $599,880

Obligatory disclaimer here that the S&P 500 is an index and one cannot invest directly in an index. An investor will incur trading costs, fees, etc. Also, an investor in an individual stock position like Netflix will likely incur some fees/costs/expenses. None of these costs are accounted for in the above analysis.

Over one million dollars in investment gains in five years! He was understandably rather fond of his Netflix position. I suppose assets that quintuple in five years engender favorability.

I asked if he thought about selling some or all of that position. Realize some of those gains. Investment gains which require two commas when written numerically. He looked at me like I was crazy. You would have thought I had suggested he throw himself off a bridge. Sell the stock that’s given me 41%/yr. for the last half a decade and added seven figures to my net worth? Unthinkable.

I checked in May of 2022 – just a few months later – and now when you compare the S&P 500’s returns to Netflix stock from the same start date used above I saw that Netflix underperformed the S&P 500 index by 8.42% per year.[iv] From the same start date used above Netflix’s total return had been ground down from 40.73%/yr. to 5.57%/yr. while the S&P 500 hummed along at 13.99% annualized. Here is what that $250K invested on the same date as above was worth in May of 2022:

  • Netflix stock: $337,330
  • S&P 500: $515,480

From over $1,000,000 in investment gains to under $100,000. That’s what a 6-month, 76% drawdown in a stock will do.[v] What a difference a few months makes…

A mere six months prior, the idea of selling that Netflix stock for seven figure gains was unthinkable. Now that position is down 70% and has underperformed the stock market itself significantly since he bought it. Two commas are no longer needed to delineate the gains in our friend’s position. This is the Winner’s Trap – the better an asset performs, the harder it is to sell. And the greater your gains in a position, the greater your potential losses.

The Winner’s Trap is a mental prison of four psychological biases…

The Endowment Effect: we are more likely to retain an object we own than to acquire the same object when we don’t own it. This is why so many brands allow you to purchase an item with the ability to return it (with free shipping!). Once you have it, you’re unlikely to give it up. The same applies when buying individual stocks.

Recency Bias: we ascribe higher odds to something happening simply because it happened recently. When Steph Curry has drained three consecutive shots from downtown, we’re certain the next attempt will be good too. But the last three made shots have nothing to do with the results of the fourth shot attempt. When you earn 41%/yr. for half a decade in Netflix stock, it feels like the next year will provide outsized returns. But the last five years have nothing to do with the next one.

Confirmation bias: we ignore or discount new information that contradicts our pre-existing beliefs while seeking out and overweighting information that supports them. You don’t need an example for this one, you see it everywhere. If you don’t believe me, ask someone about politics. Individual stocks often become narratives, and information that contradicts the narrative is easily discarded. Streaming is going to take over television and Netflix has a permanent first mover advantage. That’s a nice story. With plenty of supporting evidence to help explain Netflix’s skyrocketing stock price. Tiger King! But when you own Netflix stock you’ll likely dismiss evidence of competition in the streaming space, password-sharing problems, and lack of additional growth markets. Which turn out to be the very reasons for the stock’s precipitous fall.

Anchoring: our decisions are influenced – often subconsciously – by a particular reference point (an “anchor”). This one is often the most difficult to identify and therefore the most pernicious. Did you know you’re more likely to purchase a vehicle if it’s placed next to a more expensive vehicle? You will subconsciously anchor to the more expensive vehicle’s price and thus feel the car next to it is a good value. Frighteningly, this is true even when the reason for the price disparity is obvious – you are more likely to buy the Camry simply because it’s sitting next to a Porsche. More people will buy a $300 bottle of wine at a steakhouse if there is one listed on the page for $900.* When we own individual stocks, we anchor to the stock’s previous high.** It’s difficult to sell a stock for $500 that you bought for $100. It is far more difficult to sell that stock for $600 if it was $800 a few months ago. Your profits are larger in the second scenario, but they’re far more difficult to realize because you’re anchored to the $800 figure. It feels like a $200 loss rather than a $500 gain.

So perhaps you do overcome the overwhelming odds and pick one of the miniscule number of stocks that provides outsized returns.

But then you’ll find yourself in the Winner’s Trap.

Even if you win, you may still lose.

Sean Cawley, CFP®

*Marketers are aware of the anchoring effect and use it to manipulate you every day, by the way…

*To be fair, this is not unique to individual stocks. The anchoring effect is a hurdle all investors will encounter, regardless of what they invest in.  

Neither asset allocation nor diversification guarantee against investment loss. All investments and investment strategies involve risk, including loss of principal.

Content here is for illustrative and educational purposes only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy. Results will vary. Past performance is no indication of future results or success. Market conditions change continuously.

This commentary reflects the personal opinions, viewpoints, and analyses of Resolute Wealth Management. It does not necessarily represent those of RFG Advisory, clients, or employees. This commentary should be regarded as a description of advisory services provided by Resolute Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time without notice.

[i] “Do Stocks Outperform Treasury Bills? Hendrik Bessembinder. Journal of Financial Economics. 19 January 2017.

[ii] YCharts, Fundamental Chart, SPX Total Return Level 11/01/2016 – 11/01/2021

[iii] YCharts, Fundamental Chart, NFLX Total Return Level, 11/01/2016 – 11/01/2021

[iv] YCharts, Fundamental Chart, SPX & NFLX Total Return Level, 11/01/2016 – 05/11/2022

[v] YCharts, Fundamental Chart, NFL % Off High, 11/17/2021 – 05/11/2022