(Note: This is a continuation of the series on the risks when buying individual stocks. The series starts here.)
When buying individual stocks, one great stock – one gem – can make up for a lot of stocks that go nowhere, especially if you hold it for a long period of time and allow it to grow. Stocks such as Microsoft, Apple, General Electric, Home Depot, IBM, and Berkshire Hathaway come to mind. Each of these stocks, if purchased in the early days of the company, would have provided a sufficient return to make the investor a millionaire.
Because the upside is limitless while losses are limited to whatever was initially invested, one does not need to be right with every pick. One just needs to be right with a few picks.
The issue though is trying to find the gems. Not everyone is skilled at finding the companies that will outperform their peers over long periods of time, and even for those who are, bad things can happen to good companies. A few years ago, it looked like Iomega was going to become huge with their large external disk drives. With people starting to use digital cameras, the need for large amounts of data storage was a huge need. Unfortunately, several competitors also entered the markets and Iomega quickly lost market share. While the idea was great, the stock that looked likely to be the leader in the market did not live up to its promise.
When one picks poorly, there are really two types of losses. The first is the actual money that is lost when the stock declines in price. The second is the lost opportunity – the gain that could have been had if the money were invested elsewhere. While the loss of money may sting initially, as time passes and you have less time left during which to build your nest egg, lost time becomes just as important.
Here are some steps to take to reduce the risk of having a bad stock pick ruin your portfolio:
1. Become an investor in companies rather than a trader of stocks. This means that you buy stocks based on the fundamentals of the company. Think of yourself as actually buying into the business as a partner and choose accordingly. Too many people get caught up in trying to find price patterns.
2. When in doubt, pick the “best in show.” In each industry, there tends to be one company that is the clear leader and several others that are trying to catch it. There is usually a reason that a company is a leader, so looking at the leader first is usually a good idea.
3. Use sufficient diversification. While the idea is not to be as diversified as a mutual fund (that would defeat the whole purpose), using some diversification will certainly reduce your risk. This particularly reduces the risk of special events like corporate fraud destroying your portfolio. When you first start investing and you only have a small amount (say a couple of thousand dollars), you may only have one stock. You are taking the risk of losing the whole amount, but then again it is not that much to lose (you can re-earn it in a few months). You should quickly diversify into two to three stocks, however, as you raise more money to invest. Just remember to never have more in one position that you are willing to lose. Each stock should also be in a different industry.
4. As you have big winners, reduce the positions and spread out into additional stocks. Nothing is worse than having a stock do well, only to fall apart. If the stock doubles, consider selling off half and making an investment in another company.
5. Use the right tools to select stocks. Good stock picking does not come from reading Yahoo message boards or watching CNBC. Get a good source of data such as the Value Line Investment Survey (or read the copy at the library). The data source should give earnings for several years – you’re lookig for steady increases in earnings, along with information such as debt (less is better, none is best), predicted earnings growth rate (10-20% per year is best), and return on equity (at least 15%).
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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: Ewa Kubiak, Website http://sesja-zdjeciowa.pl , downloaded from stock.xchng