How Safe and Profitable Are Individual Stocks


Dear SmallIvy:

Burning Question: I am trying to learn about Stocks etc. I purchased 2 shares of Warner Music Group yesterday through Robinhood, an app I downloaded. I read your article after the purchase 😩 but still, I bought what I could afford. I am 46 and a Medical Assistant and I don’t make very much money. But I’m trying to learn how to invest. My question is…will it still be financially safe/profitable for me to slowly get up to at least 100 shares as I can?

Jamie

Dear Jamie,

First of all, let me congratulate you on getting started into stock investing.  It is a great way to magnify your income from work, save up for big expenses in the future, and give yourself something to fall back on if things get tough.  It gives you a lot of security and financial peace that a lot of people who spend everything every month never have.

On the question of safety, there are two factors in investing risk, which are volatility and time. Volatility is set by what you’re investing in. Time is both how long you have to invest and how much flexibility you have in when you sell. Let’s talk about each of these factors.

Volitility

Volatility is how rapidly an investment can change in price.  This translates to risk because investments that change price rapidly can drop in price very quickly. A bank account has very low volatility – you are nearly guaranteed that the value will be whatever you put in, plus interest. As an example, real estate has higher volatility. If you buy a house for $200,000 this week and need to sell the next month, you might get $200,000, or you might even find someone willing to pay you $210,000. But you might also get only $180,000. (People think of home buying as low risk and low volatility, but that is because they only see price changes after several years when they want to sell. If you saw the price someone was willing to pay for your home everyday, you’d see gains and losses of thousands of dollars frequently.)

Individual stocks are fairly volatile. This means that your potential for quick gains is good, but also means you could have a large loss very quickly. Another way to invest in stocks, mutual funds and ETFs, are less volatile since they invest in several different stocks at the same time. This way, if anything bad happens to one company, the decline in its price is only a small portion of your investment so you don’t lose as big a percentage. Conversely, if good things happen to one of the companies and the price shoots up, you don’t get as big a percentage gain since it is still just a portion of your investment. (I cover the volatility/risks of investing in everything in which most people would invest in The SmallIvy Book of Investing.)  

For an individual stock like Warner Music Group, it can easily go up or down by 20% in any given week (or even in a few minutes).  There are also times where it will double in a week or fall 50% in a week.  If some really bad news comes out for the stock itself, it can fall 80-90% immediately and then perhaps keep going, slowly wasting away to $0.  I find that maybe 1 in 30 or 1 in 50 stocks go out-of-business entirely, causing me to lose my entire investment.  It is more common to have stocks that fall maybe 30-50%, and then not really go anywhere for a long time.  In that case, you would have been better off putting your money in a bank CD. This is a risk you take when buying a single stock.

Time

The other factor is time.  Time has the effect of reducing your risk, so holding a volatile investment for a long period of time is of equal risk to holding a lower volatility investment for a shorter period of time. This is because most of the movements in price for a stock, for example, are due to random things which don’t last very long. It is true that a bunch of investors can drive the price of a stock down if they get worried and want to raise some cash, but the stock price will not stay down forever, just until the current issue passes and people start to buy again.

A good way to think about it is to think of the ocean with the ripples, the waves, and the tides. The ripples and the waves cause the level of the water to move up and down all of the time in an unpredictable way, so if you were to stand out in the water and face the beach, it would be difficult to predict what the water level around you would be in 20 or 30 seconds. If you started to observe the tides, however, you could predict that the water level would be higher in 8 hours if you knew the tides were coming in. So you could predict that in 8 hours you would effectively know the water level would be higher and even predict what the range of water levels would be based on the average size of the waves and ripples.

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So, let’s say that you make a bet with someone that the water level will be over your waist, standing in the water at some place where the water is coming up to your knees. If you made the bet that this would happen within the next 10 seconds, you might luck out and win if a big wave came along right then, but you might just as likely lose if no wave came. If you were to predict it would happen within the next 24 ours, however, you would certainly win because you could just wait until the tides were high enough and then wait for a wave to come to win the bet.

If you hold shares of a company that has growing earnings and especially one that has a growing dividend, the price will eventually go up to match the rate at which the earnings are increasing.  If Warner Music makes twice as much next year as it did this year, the price is likely to go up near $60 per share, doubling from where it is now.  This is assuming that the ratio of the stock price to the earnings the company makes, called the “Price/Earnings ratio” or just the “P/E Ratio,” remains about the same. In general, the P/E Ratio for a company will stay within some range, so it is reasonable to expect that a company that sees its earnings double will see its share price double at some point in the future, if you wait long enough.

But if the whole market falls like it just did, taking the share price of all companies down, or if the economy gets effected so that Warner Music doesn’t double their earnings, the price may not go up by next year.  But if you wait long enough, these random events go away and the stock climbs up to where it should be in price.  The longer you are able to wait to allow your stocks to perform, the lower your risk.  If you have all of the time in the world, you can just wait until your stock goes up and sell.  You don’t need to sell next year, regardless of where the stock price is.  Given that you’re only 46 and have 20-25 years of work and income ahead of you, you have plenty of time.

So, what you should be focusing on if you’re investing in individual stocks is not what the price is doing but what the potential is for the company to increase their earnings. Because price will generally follow earnings, just as the tides will follow the movements of the moon, you will know that if you invest in a company that has earnings increase, the price of your stock will go up. There will always be fluctuations in the price of the stock, but the average level on which those fluctuations occur will increase if the earnings increase. If you buy stocks that have a great product, a good management team, and have a lot of room to grow, you are likely to see increases in share price in the future.

Unfortunately, the earnings of a company are not as predictable as the movements of the moon, so you can’t look at stock XYZ and know that earnings will be two times what they are today in five years. (But if you could, the stock price would already reflect this, so you would get no better returns than you would in a bank CD.) For this reason, you buy more than one stock, such that the stocks where you are right and that you do see their earnings increase offset those for which you are wrong and things don’t work out. You also buy some stocks that have more predictable earnings, and therefore a lower return, along with stocks that have less predictable earnings but greater potential returns. This is why, for example, I own shares of Clorox, which has fairly predictable sales, along with shares of Johnson Outdoors, which has less predictable earnings but has the potential to grow a lot faster than Clorox. Clorox also pays a dividend, which means I’m getting a return there even when the stock price is stagnant.

Before you can start investing, you need money to invest. Please check out my latest book, FIREd by Fifty: How to Create the Cash Flow You Need to Retire Early. You’ll learn how to control your cash flow so that you’ll have money to invest and grow wealth.

Consider the Consequences

One final point is that risk is made up of both the likelihood that something bad will happen and the consequences if it does.  It is definitely possible that your investment could go down to $0 and you lose it all if you invest in a single stock. The question to ask yourself, then, is:

“Would the loss of my investment be devastating to me? ”

If you lost $3000, the price of 100 shares of Warner Music stock, would it mean that I wouldn’t be able to pay some important bill? Would it set me back years, making it tough to recover? Will I miss something important if I lose that money? Once any single stock investment gets large enough that the answer to any of these questions is, “yes,” then it is too large and you should protect yourself against loss. If the answer to all of the questions is, “no,” then you can make the bigger investment since then you have the chance of using that volatility, combined with the long investment time, to make a better return than you would if you chose a less risky investment.

If you wanted to invest more safely, you could choose mutual funds or ETFs instead. This would reduce your potential returns, but also make your returns more predictable and make it almost impossible that you could lose everything you invest. For example, you could invest in an ETF like QQQ (known as “The Q’s”), which invests in several stocks, and reduce that likelihood of losing your entire investment to essentially 0% (the Qs will be worth something unless the entire economy dissolves and we’re all fighting each other for food).  But it is most likely that you will make about 10% per year in the Qs on average.  In 10 years, you’ll likely be up to somewhere between $5000 and $7000 if you start investing regularly and put $3000 in $QQQ. 

If instead you build up to putting $3000 in Warner Music, getting the 100 shares you mention, you could see it up by 200%, 500%, or more over that same period.  This means your investment could be at $9,000, $18,000, or even $20,000+.  On the downside, it is very unlikely that $QQQ will be worth less than $3000 in 10 years, while there is maybe a 70-30 chance whether Warner Music will be above $3000.  (Note, I’m just pulling numbers out of the air here based on my experience, not based on any actual data. Chances could actually be 80-20 or 60-40. or some other number. The point is that it is in your favor, but no where near a certainty.) It might be at $20,000, but it could also be at $300. 

So, the question to ask yourself is if the chance of losing $3000 worth the chance of making $15,000, or would you rather be almost sure of having $5000 to $7000 in 10 years.  What would be the consequences to you of losing $3000, or of not having at least $5000 in 10 years?  Note that if you spread your investments out to 5 stocks, instead of putting everything in Warner Music, it starts to look more like investing in $QQQ, where your chances of being down decrease but your potential gain also decreases. The more stocks you buy, the more like an ETF or mutual fund your portfolio looks.

Have a burning investing question you’d like answered?  Please send tovtsioriginal@yahoo.com or leave in a comment.

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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.

2 comments

  1. Just wrote a bunch about this! The decision between buying individual stocks and index funds yielded my most expensive money mistake!

    After reading Jamie’s question, one thing that stuck out to me is the risk of individual stocks going to zero. While index funds could technically bankrupt, that would be indicative of a large market failure like we haven’t seen.

    Seeing large companies go to zero and individual investors get wiped out during the 08-09 Recession really caused me to miss some sleep like I hadn’t expected. Stocks going up and down is one thing, but a chance of losing all value is another.

    • I’ve probably had 10 stocks go to $0 or down so much that they were effectively $0 over 40 years investing. Right now, Chicos FAS is circling the drain in my portfolio. It is rate, but certainly a possibility. You need to make sure that you have enough diversification to protect yourself. I never keep more than 5% of my net worth on any 1 investment.

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