The Risks of Investing in Individual Stocks


Investing in individual stocks is definitely different from investing in mutual funds.  It requires a different strategy and a different psychology.  The swings in value are a larger for individual stocks than for mutual funds and if done wrong, one can either have returns that lag well behind the market or even lose a great deal of money.
When investing in a mutual fund, you are pooling your money with others to invest in a large number of companies.  While you may have some stocks in the fund that do poorly or even go bankrupt, the effect of a sharp decline or even disappearance of any individual stock is usually fairly small.  If you have 100 different stocks in the mutual fund, with each stock representing 5% of the fund, your would only lose 5% if one of the companies went bankrupt entirely.
This means that your losses are limited, but it also means that you will, at best, track the market over long periods of time.  Even if a fund you have has a good year or two, there are just too many stocks in the fund to beat the market if you hold long enough.  The fund also must charge fees, which act to reduce your return. Finally, when a fund does well and a lot of people start to invest in it, the manager is forced to buy a lot of stocks that are not his first picks in each sector since he must stay fully invested.  For example, he may like Lowes a lot more than Home Depot, but he must buy both because he has too much money to only take up a position in Lowes. If he does not and instead keeps a lot of cash, he risks lagging behind the market if it advances because of the cash position he holds.
As an individual investor without the large amount of cash controlled by a mutual fund manager, you do have the ability to buy only your top picks in each market sector.  By buying individual stocks, you have a chance to beat the mutual funds and the markets.  If you pick a huge winner, such as Apple was a few years ago, it can also make up for several bad picks that you make.  The beauty of stocks is that there is a limited downside but a virtually limitless upside.  Pick up a few hundred shares of a Microsoft in the early days and hold it for a long time, and your retirement can be set.
There are special risks with investing in individual stocks, however.  Over this next series of posts, I’ll go into each of these risks in more detail and how to deal with them.  The specific risks are:
1.  Account value can change rapidly because share prices are unpredictable over short periods of time and do make large price swings.

 

2.  You may not be good at finding good companies to invest in.

 

3.  You will become a trader instead of an investor, and your returns will suffer.

 

4.  You will look at stock returns as you would other investment reutrns and let that affect your investment decisions.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Picture Credits: Thomas Picard, downloaded from stock.xchng

Setting Up an Investment Account for your Kids


One of the best gifts you can give your children is a small investment account when they leave the house.  If you can start them out with a portfolio of maybe $10,000 to $20,000 in stocks, they will have the money for a down-payment on a house when they are ready and money to draw upon as needed.  By starting them in investing, you are also making it more likely that they will become lifelong investors.  This in turn will lead to financial security in their lives.
Believe it or not, building an investment account of such a sum for them is really not as difficult as it may seem.  When they are born you also have 18 years until the time they’ll be an adult.  If you are able to average around 10% from the investments, that is enough time for the funds to double almost three times.  This means that an investment of just $2000 may be worth around $16,000 by the time they are going off to college.  Of course if the market does very well, as it did in the 1980’s, the account may be worth a lot more.  If it doesn’t, like in the 1970’s, it may be worth a bit less.
Obviously the first step is finding the money to fund the account.  Most mutual fund companies require minimums of $5,000 or more.  Vanguard, which is one of the better companies for small investors, requires a minimum of just $2,500 for many of their funds.  If you have received a lot of monetary gifts for the new baby, consider putting these away into a mutual fund rather than spending it all on baby stuff.
Once you’ve saved up enough money to meet the account minimums, select one broad-based mutual fund and set up a custodial account for your child.  You are looking for a fund that invests in a large sector of the market, rather than a fund that is concentrated in any one area.  You are also looking for a fund with low fees and expenses since the difference in fees and expenses is typically what makes the difference in performance for funds over long periods of time.  You may consider an index fund, which typically has the lowest fees of all.  Avoid funds that have large fees for purchases or redemptions.
When selecting a mutual fund, avoid the temptation to pick a fund that has done well over the past year or the last several years.  While it is tempting to pick a winner and assume you will get similar returns during the next several years, a fund that has done well may actually lag behind others over the next several years since the stocks it now owns have already gone up in price.
After the initial investment, try adding to the fund during the first few years as you can.  Perhaps add some of the birthday money received (you’ll find that they quickly have plenty of toys and clothes are outgrown almost instantly) and some extra funds you have.  Don’t worry too much about how the fund performs during any given year- there will be good years and bad years.  Trying to time the market by jumping in and out will normally result in poor performance.  If it helps you psychologically, save up money and invest more during dips.  The important measure is how the fund did versus the return of the market.  If your fund consistently underperforms its market segment by several percentage points, say over a period of three years or more, you should think about switching to a better fund.
Once the fund has built up to a substantial size (say maybe $10,000), you may consider selling some of the fund shares and buying another fund to increase your diversification.  For example, if you have a large-cap fund, you may consider selling half and buying into a small cap fund.  Be aware, however, that the sale may well result in capital gains, which may then require a tax return be created and perhaps taxes be paid.
Maintenance of the account is fairly easy.  As stated above, once the account becomes large, or if you move funds from one mutual fund to another, it may be necessary to prepare a tax return – check with your accountant for the minimums.  If you do not move things much, however, and the funds you select do not generate many dividends or capital gains, this may not be necessary.
Once your child turns 18, they will then have full control of the account.  You have no choice in this.  Well before that point (perhaps starting when they are around 10), it is important to start explaining investing to them and let them follow their account.  By watching their account grow, they will (hopefully) realize that by leaving the account alone, they can have their wealth grow.
You can explain to them, for example, that if they just spend some of the gains, rather than selling all of the shares and using the principle, they can both have money to spend and the original money.  Each year, show how much their account balance increased and how they could take some of that increase and let the rest remain to purchase more shares.  On down years, show them that they can purchase more shares at the lower prices and be in even better shape the next time the shares rise in price.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Photo by Milan Jurek, downloaded from Stock.xchng.

Spending for Tightwads, A Three-Step Process


OK, I’ll admit it, I’m a tightwad.  After putting a lot of effort into saving and investing, I find it hard sometimes to loosen up the purse strings.
The fact is, you really need to be somewhat of a tight wad early in life if you want to make your way to financial freedom.  If you are spending like everyone else around you, you’ll be broke like everyone else around you.  You need to be putting money away while everyone else is taking out loans, paying cash while everyone else is pulling out the credit cards, and be cooking at home while everyone else is going out every night.
The trouble is, after being in that mode of saving and investing for a while, it becomes difficult to realize that maybe you don’t need to pinch the pennies quite so tight.  You can loosen up a bit when you go out on the town or head out on vacation.  Because you’ve planned, saved, and invested, your income should be higher than that of most of your peers.  Even better, your should have a lot of free cash flow since you should have money coming in from assets each month rather than being obligated before the month begins by liabilities.
For fellow tightwads for me, I’ve devised the following three-step process:
Step 1:  Budget
Yes, I can feel all of the spouses of tightwads out there, who thought this article would help reform their avaricious spouses, collectively sucking in a breath.  I know that budgeting is normally associated with skimping and saving.  I think a lot of people pinch pennies a lot tighter than they need to, however, because they don’t really realize how much they have available.  How many people do you know who seemed to live in poverty their whole lives who then die with multi-million dollar estates?  I’m sure you know of at least one such person.
Personally I hate being in situations where I’m being asked about a proposed expense (for example, being at a restaurant and being asked if we should have a $10 dessert) because I instinctively say, “No,” if something seems pricey.  If I know that we have plenty of money remaining for eating out, however, I can happily say “Yes,” knowing that the overpriced dessert won’t put me into financial ruin.  Better yet, if I and my wife are on the same page, she shouldn’t even need to ask – we should have agreed ahead of time so I don’t end up in the role of financial gate-keeper.
Step 2:  Review Your Pipelines and Budget some Spending as Appropriate
As stated previously, your pipelines are assets you buy that will provide income to you in addition to your regular income from your job.  These are things like bank CDs, stocks, bonds, and rental properties.  In order to become and stay wealthy, you should be using some of your income to buy assets and build your pipelines.  You should also be reinvesting a lot of the income received from your assets into more assets, since that is the way you turbocharge your wealth creation.
As you start to build up a large income from assets, however, you should start to use some of this additional income for spending and giving.  You should also perhaps think about cutting back on the amount of money you are putting into buying assets from your wage income.  When you are 20 years old, putting as much away as you possibly can into an IRA should be your first priority.  If you are 60 years old and have several million dollars in assets, however, that $5000 contribution to your IRA really won’t make too much of a difference.
While I’m not saying you should go wild and spend everything you have saved, maybe you should look at increasing the amount you budget for spending and saving each month.  Maybe carve off a percentage of the money you are receiving from your assets for a vacation or a kitchen upgrade.  Maybe designate some of the interest from your assets for donations to your church, causes you believe in, or (most fun of all) for giving anonymously to those around you who need it.
Step 3: Execute
Once you have your budget and spending plan, do the steps needed to execute it.  If you have a budget for eating out or hobbies, you may wish to withdraw cash each month and place it in an envelope specified for that expense.  Then, as long as you have money in the envelope for that expense, you can spend confidently since obviously you aren’t going over your budget (no cheating with credit cards).  If you plan to spend a certain amount for home upgrades each year, you may want to pick a date at which you free up the needed funds and deposit them into your checking account so that you actually do it.
Just as you may automate things when saving, you may also wish to automate some of the allocation of dollars for spending or giving.  Perhaps create an account for vacation spending and have some of your paycheck automatically deposited in it each month.  Perhaps have a checking account for giving setup and then write a check when different charities come knocking or you find out about someone in need.  If you have a lot left over at the end of the year, maybe send the balance to your alma mater (just make the donation anonymously so they won’t be hounding you monthly after that) or pick up the check for some strangers in a restaurant during the holiday times.
I am certainly not advocating taking up the “normal” spending ways of those around you.  If you do that, you will quickly find yourself in the same financial condition as them.  If you do the correct planning and budgeting, however, you can transition from a tightwad to a person who does things and gives to those in need in such a way that some of those around you may change into a bit of a tightwad themselves.  Hey, if I can do it, so can you!

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Photo Credits: Penny Mathews, Website http://www.credos.us/zoofythejinx, downloaded from stock.xchng.