Many financial advisers and personal financial pundits will say that you should not invest in single stocks. You need a large amount of diversification (the holding of a lot of different stocks) to lower your risk. Investors should therefore only hold mutual funds, which buy a large number of stocks.
They are right that investing in mutual funds is the safer way to go. History is littered with examples of companies that collapsed, leaving the investors with large losses that they could never make back because the company they had invested in was no longer there. Generally if your company files bankruptcy, you can expect to get nothing for your shares. Management, the workers, other creditors, and the bond holders will take what they can, so there will be a couple of pennies on the dollar leftover for the shareholders if that.
There has never been a holder of a mutual fund who saw his whole investment wiped out, because that would mean hundreds of companies failing at once. If that happened, the whole economy would be imploding and you’d be out hunting squirrels in your backyard to eat. (By the way, this is why the argument that having people invest for retirement with individual accounts in mutual funds rather than having the government-run Social Security program because investing in the stock market is too risky is a really stupid argument. If the mutual funds imploded, there would be nowhere for the government to raise the money to pay Social Security payments either because no one would be working and there would be no corporations anymore!) In general, if you just hold on after a market downturn, you’ll see your investment recover within a year or two. Even better, invest more at these times since the markets generally overreact and under-price things, allowing you to swoop in and get shares in good companies for a great discount.
Still, holding only mutual funds limits your potential investment return. Having a portion of your portfolio in stock mutual funds makes sense since it virtually guarantees you a great, inflation beating return that has ranged from 10%-15% over long periods of time since people have been keeping track. It is where your 401k retirement funds belong, and where your individual IRA funds belong if you don’t have a 401k available to you. Having a portion in bond funds and income funds also makes sense as you are nearing the time when you’ll need the money since then you can generate regular income and not need to rely on selling stocks and capturing capital gains when you need cash. This is important since you really can’t predict what the markets will do from year-to-year.
Individual stocks, however, can return far more than the markets. Look at companies like Microsoft and Home Depot. If you invested a few thousand dollars in either of these companies in the 1980’s and just locked your shares away in a safe deposit box, you’d be a multimillionaire today. If you put that same cash in a set of mutual funds, you’d have maybe half a million dollars over the same time period. The difference is that a small company can double its earnings and become far more valuable many times over as it grows and matures. An entire market, that includes stocks that grow and become big, others that fail and disappear, and still other that just grow to a certain level and then stagnate, cannot do the same.
The issue though is that many people start to think they are high-power Wall Street Traders and try to beat the markets by shifting from company to company as they hear news, see some movement in the price of a stock, or get a tip from a friend at work. One of the silliest commercials on television today shows a father who talks about the “rush hour” in their home at 6:30 as his kids and wife get ready and head out. He, on the other hand, just sits down at his computer to trade stocks for the day, still dressed in a long sleeve white shirt and slacks to make him appear like someone in high finance.
The truth is you will never be able to beat the markets over the long time by moving in and out of stocks, taking profits and limiting losses. Every piece of news that you hear causes the markets to react before you get a chance to click a button on your computer or call your broker. There are thousands of others out there ready to pounce on the same news. You also won’t be able to find some pattern in the price movements of the market and deftly jump in and out before major events. Most of the time, charting stocks just tells you where you are rather than where you are going. Any reliable pattern indicator that does show something like an inefficiency in the markets that can be exploited is soon discovered and eliminated as everyone piles on. The only way you can actually take advantage of market inefficiencies is through arbitrage, where you find the same stock on two markets at different prices and buy on one market and sell on the other, but professional trading firms with lightning fast computer quickly exploit those opportunities.
The way you outperform the markets is to start thinking like an investor instead of a trader. In other words, thinking like an owner of a company instead of just a stock holder. You find companies that are managed well in markets where they have the potential to grow and make lots of money in the future. You then buy into these companies with the intention of holding them as they grow.
This isn’t a short-term thing where you’ll sell out once you’ve made 20% or doubled your money. This is a long term commitment where you’ll hold on through think-and-thin since you know that brighter things lie ahead. In down markets you know that your company will be able to take market share and become more efficient while competitors go out-of-business. In boom times you can enjoy watching your company grow and expand, but you know that it will get even bigger and more profitable in the future.
This is what it means to be an owner. Instead of acting like someone who bought a few shares on E-Trade, you act like you put $5,000 into your cousin Evan’s garage start-up. You know that you may not get the money back, but you have confidence in Evan and know that he has a great idea and the return you could get would dwarf your investment.
In the next post in this series, I’ll discuss how investing like an owner changes the kind of companies you pick.
I’d love to hear your comments! Please use the comment form and let me know what you think, especially if you disagree. You can also contact me at firstname.lastname@example.org.
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. 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. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.