The Best Way to Invest in Individual Stocks

Individual stock investment, where you buy shares in individual companies instead of putting money into mutual funds, is often discouraged by financial planners.  They point out that there are all sorts of professionals out there who have better information, better technology, and better connections than you do.  They also point out that most professional money managers don’t do as well as the average returns of the markets.  They point out that investing in individual stocks is risky.  And they are right.

And yet there are people who do very well investing in individual stocks, including people who become millionaires.  I remember a story I heard at a shareholders’ meeting where a woman who had held shares of the company for many years called up to complain that the price of her shares had gone nowhere.   The company, whose shares had split many times (meaning they cut the price of the shares in two but then issued each person two shares for each share he owned), figured out how many shares she now owned since she had held the company for so long.  The woman calling to complain about the lack of performance of the company was shocked to hear that she was, in fact, a millionaire.

While this is not the norm – not everyone who invests $10,000 in one company becomes a  millionaire – there are still a lot of people who do become millionaires and even multi-millionaires by investing in individual stocks.  There are many who have returns much better than they would have seen if they had simply invested in mutual funds.  The numbers are much higher than the number of boys who grow up and get a job in the NFL or people who win the lottery.

The difference is the way that these investors approach individual stock investing.  They do things to put the odds more on their sides – things that professional money managers just can’t do because they have too much to invest and are driven for quarterly results.  Successful individual investors put themselves in a position to benefit when they are right and the companies they buy stock in flourish.  They are what I term serious investors, in contrast to the thousands of people who say they are investing, but really they’re trading or speculating.

If you want to put the odds in your favor when investing in individual stocks and be a serious investor, here are some steps to take:

1.  Set up a back-up plan.  Before you ever consider investing in individual stocks, you should take the actions needed to protect yourself should things not work out well.  This means putting enough money into retirement accounts, such as 401K’s and IRAs, to provide the income you’ll need for retirement and investing these dollars in mutual funds.  You should invest between 10-15% of your income for retirement, with at least 10% going into mutual funds.  This will put you in the position to have a safe and secure retirement, far better than that of many of your coworkers who don’t save for retirement until very late in their careers, even if none of your stock picks work out.  This also means that your need for retirement income won’t affect your individual stock investments.  You won’t need to sell stocks just because you need to keep the heat on in the winter.  Your retirement accounts are your bedrock foundation.  Your individual stock purchases are the skyscrapers you build upon your foundation.

2.  Pick stocks like you were becoming a partner in the business.  If you were looking to make a large investment in a private business, you wouldn’t find a business to invest in by looking at the prices people recently paid for businesses and selecting one that had gone up or down.  You might use that information when evaluating a fair price for your stake, but the price movements alone wouldn’t be the main reason you would buy in.  In fact, if the price had recently doubled, you might be wondering if you would be paying too much and pass, waiting for a business in which you might get a better entry point.

Instead you would be looking at things like if the business was turning a profit and if that profit was growing.  You would look at the people running the business and see how skillful they were at their jobs.  You would be looking at how big the market was that the business was involved in and what opportunities the business had to expand.

You should be looking at the same things when picking a public company as an investment.  It is true that your share of the company would be a lot smaller if you buy into a publicly traded company with thousands of employees than it would be if you were buying into a local pizza restaurant, but the ideas are the same.  You make money when the business grows, and the things that make a business grow are a good management team, a good product, growing profits, and opportunities to continue growing.

3.  Be ready to hold for a long, long time.  How well a business will do over a period of a few weeks or even a few years is very unpredictable.  This is because all sorts of factors can influence the price.  The economy may boom or enter a bust cycle.  The price of energy may rise or fall.  The government may create a new regulation or remove an old one.  The company may make a misstep and see earnings decline, or they may make earnings as predicted but investors expected earnings to be even higher.  The price of a stock over short periods of time is as difficult to predict as predicting when it will rain.

Over long periods of time, however, well-run companies that grow earnings will see their share prices increase.  They will grab market share, sell more products, and become a more valuable company.  You put the odds in your favor by holding onto stocks for a long period of time, waiting for the company to grow and the stock price to grow accordingly.  You don’t need to be right about when the stock price will do well, just that it will eventually do well.  Be prepared to hold for ten or twenty years or longer, giving time for your company to grow to its full potential.

4.  Buy enough shares to make a real difference.  If you had bought 100 shares of Microsoft during its first year of active trading, then held onto your shares and never sold any, you would be a millionaire today.  The same thing goes for Home Depot, Wal-Mart, and a few other exceptional companies.  There are a lot more companies, however, where your position might be worth only $100,000 today.  You increase your chance of doing really well and having life-changing investments when you buy enough shares to really make a difference when share prices increase by 100% or maybe 500% instead of only the few times when they increase by 5000% or more.

While you should spread your investments out into a few different companies (maybe 5 for a $50,000 portfolio, 10 for a $200,000 portfolio, and 20 for a $500,000 portfolio), you should concentrate your investments such that a 100% increase in price would make a serious impact.  Usually this is a position of 500 to 1000 shares.  For example, holding 1000 shares of a company that trades for $30 per share would result in a gain of $30,000 if the stock went up to $60 per share.  Contrast that with a 100 share position, which would result in only a $3000 gain for the same increase in price.

That said, positions should not be so large so as be financially devastating should a position collapse, because that happens with individual stocks.  If you have a million dollars to invest, holding a $50,000 position would be reasonable since the loss of $50,000 would be painful, but you could recover from it with your other positions.  If you only have $50,000 to invest, that would be a different story since if you lost the entire position it would take a decade or more to recover.  You should therefore limit positions to maybe $10,000 or so.

5.  Sell when the company is no longer set for growth, not because of the share price.  Once again, if you bought into the local pizza restaurant, you wouldn’t be looking around to sell when the company went into a slump.  You also wouldn’t be looking to sell when the business just started to pick up.  You would only sell when 1) you needed the money or 2) the restaurant either obviously couldn’t make it or there was no more room for growth (and even then you might hold on if it was generating a good income stream).  Public stocks are the same way.  Movements in the price are not reasons to sell.   Sales should be done when you need the money or something fundamental has changed at the company, such that the money could be better invested elsewhere.

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.

Comments appreciated! What are your thoughts? Questions?

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