In some of the funniest radio I’ve heard in a long time, Dave Ramsey (of the Dave Ramsey Show) responded to an emailer’s question, in which the caller asked what she should do with her BP shares, now that they have declined. He screamed into the radio, to paraphrase, “I don’t buy single stocks, because you never know when the company you buy will dig a hole into the bottom of the ocean and kill everything in the vicinity!!!”
For those who don’t know, Dave Ramsey is the author of a series of books and the host of a popular radio show. The theme of the show and the books is getting out of debt and generally getting your financial house in order. Clips can be heard at their website, http://www.daveramsey.com/radio/home/ . He offers great advice on setting yourself up into a position where you can start investing and growing wealth (by getting rid of all of your debt and spending less than you make so you can invest).
Mr. Ramsey’s shuns individual stocks. His investing style is to buy mutual funds. Specifically, he spreads his investments over mutual funds in the categories of growth, growth and income, aggressive growth, and international. He does not buy individual stocks because he believes the risk to be too great. And as he said, you never know what will happen with any one stock you own. It may actually drill a hole in the bottom of the ocean. Or it may just really misread demographics and see earnings implode.
While I do not agree that mutual funds are the only way to go, ownership of only one stock is not advisable, and the number of stocks owned should grow as one’s tolerance for risk declines. To invest in individual stocks, one must understand their behavior and plan accordingly. The price of individual stocks changes rapidly, and sometimes for no good reason. The current price offered reflects people’s feelings about the near-term prospects for the future, what the market is doing, what people expect others to do, where other investments are priced, other events in people’s lives, and recent movements in price. One cannot buy a stock and expect 10% to be added to their bank account year after year just like a savings account. Some years it will double, other years it will fall by 50%. Some years it will move up or down by 2%. Bad things do happen to good companies as well, and sometimes individual stocks fall rapidly in price, sometimes never to recover.
Because of this, placing large amounts in only one stock or even just a few stocks is foolish. There were many retirees from GE who watched their life savings implode along with the price of GE stock during the last recession. If you have large sums of money, you should spread it out over a number of stocks, and even into different sectors and asset categories (stocks, bonds, treasuries, etc…).
For those who do not have a lot of money, however, concentration in a few stocks can be a good thing. If one is a fairly good stock picker, or even picks one huge winner out of five, one can do very well. The difference is that if one has a lot of money, the risk of losing a large sum outweighs the potential rewards that can be gained through concentration. If one only has a small sum to invest, however, it is worth the risk of suffering a loss. If one only has $1000 and it grows at 10% per year, one would only have $2000 after 7 years. It is worth the risk of losing the $1000 for the potential to have $10,000 after those same seven years.
That said, you should be contributing to retirement accounts like 401Ks (10-15% of your paycheck if you want to be assured of a comfortable retirement) and investing that money in mutual funds. You don’t want to risk your retirement on your stock picking. You also want to start diversifying into mutual funds as your portfolio value grows. As some of your positions get large, sell a few shares and buy shares in a fund to start to protect your gains. The greater the portion of your portfolio that you have in mutual funds, the less volatility (meaning how much your portfolio value moves up or down) you’ll see. You’ll also be reducing your potential rate of return, however, so holding onto a few single stocks is often worth the risk. Hopefully you’ll do so well that while the percentage of individual stocks you own declines as you get older, the absolute value will stay the same or even grow because your portfolio will just get that much larger than when you started.
Here are the rules I generally use in determining the maximum size of individual stock positions:
1. Never have more in one position then you are willing to lose. If you cannot afford a loss of $1000, you do not belong in individual stocks. Very few people (except multi-millionaires) could afford to lose $100,000, so positions that grow so large should be split up into smaller positions.
2. On the other hand, make sure positions are large enough that if one is right about a stock, one make’s a good profit. It does no good to be right about a stock that goes from $20 top $40 if one only has $500 invested, since only $500 will be made. Make sure to take large enough positions so that your winners will result in a large return.
3. The more money you have, and the shorter your time horizon, the more diversification you should have. If you have a significant amount of money, or if you do not have much time to recover from a setback, your level of risk should drop. A person who will retire in five years and plans to live off of his savings should not have his money invested such that a drop in a few stocks would affect his plans.
4. Have money that is really needed in the next five-ten years in cash. Again, if you will be retiring soon, there is nothing like having enough to live on for five years in cash. It was sad to hear of so many putting off retirement because of the recent recession. These individuals should have been sitting on a pile of cash such that they could care less about the stock market drop.
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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.