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.

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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

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