Note: This will be the first post in this series on individual stock investing and I’ll be adding several more. Search “Individual Stock Investing” in the categories to find all of the posts on this topic.
Many people just stick with mutual funds and Exchange Traded Funds (ETFs) when investing. There is really nothing wrong with that strategy. Investing with funds and ETFs requires very little time to learn. If you use index funds and Index ETFs, costs are also very low. Since few active managers generate returns that exceed the returns of the indices, it normally makes sense to use index funds and save money on fees.
But there are a lot of advantages to adding individual stocks to your investment mix instead of using just mutual funds and ETFs. You can create a portfolio of individual stocks to create and shape your own index instead of using one of the commercially available mutual funds. You can also just add a few individual stocks to your mutual fund portfolio to increase your returns or give you more flexibility and limit/delay your taxes. In this first post in the series, we’ll talk about different ways individal stocks can be used and the advantages gained. We’ll first talk about how not to use individual stocks. Then we’ll talk about the advantages to using them.
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Don’t invest in individual stocks this way
Many financial advisors and internet investment gurus wisely tell people not to use individual stocks. There is truth in this idea because a lot of people do things that reduce their returns or greatly increase their risk when using individual stocks. People can also get emotional and irrational with individual stocks in particular. But investing the right way, individyual stock investing can be a useful tool to improve returns and manage taxes. Here are some ways you should not invest in individual stocks:
Time the markets: Trying to time the market is never a good idea and the main reason people fail to even come close to market returns with individual stocks. The truth is that everything you know and everything you hear (unless it is insider trading, which is illegal) is already known. That big news you heard is already priced into stocks, so you aren’t going to swoop in before the word gets out and make a quick buck. In fact, markets tend to overdo news, making things even worse. When great news comes out, traders push prices up too far. When bad news breaks, they push prices down into the depths. Often you’ll see a pull back within a day or two after a big movement as people come to their senses and correct. If you’re buying because you hear some good news, chances are good that you’ll buy into this bubble and see a quick loss within the next day or two as prices return to a more normal range and people who bought the stock before the news came out sell to lock in their profits.
Market timing is a big issue with index ETFs and funds, but it’s even worse with individual stocks. That’s because you’re likely to hear news about a stock you own or have a stock included when talking about their industry like hotels, or internet retailers, or banks. This makes people decide they must do something in response. People also tend to follow individual stocks closer than they follow mutual funds, making them more likely to try to get in after big news or out after a big move in stock price. Price movements are also larger, making it more tempting to lock in a profit after a rise or sell out to keep a loss from getting bigger when a stock drops.
You will never beat the markets with individual stocks by trading in and out. Accept that the movements are random. You’re just as likely to get a huge surge upwards that you’ll miss out on if you’re on the sidelines than you are to sidestep a big drop and then be able to get back in before the stock rises again. And even when you get the initial timing right and sell before a drop, it is often difficult to determine if you should then make a move back in or wait some more. Big moves happen over very short time periods, from weeks to days to minutes, so the risk of missing out on a big gain because of market timing is far greater than that of losing money by holding. Holding is also easier than trading, takes a lot less time, creates a lot fewer commissions/fees, and puts time on your side. If you want to be an effective individual stock buyer, buy with the intention of holding on for a long time. Select stocks that you’ll want to hold a long time. Think like you’re buying into the company, not trading a stock.
Fall in love with a stock: Sometimes we have a great pick that results in a 1000% return (a ten-bagger) or one that just keeps growing year after year. There is a danger here of falling in love with a stock and starting to believe that they can do no wrong. It’s good to hold onto winners and let them ride, but sometimes our judgement gets clouded, the company changes, and we hold on far longer than we should have and lose a big gain.
Always review you positions with a critical eye and look for signs that some of the luster is being lost. Has management changed and are the new leaders as effective as the old ones? Did the markets change where now there are new competitors where there were none? Has the company grown to the point where there is not much left to go for growth? Will there product become irelevant due to changes in technology or tastes? Has the stock price gone so far up that it will take many years for earnings to catch up, such that you’re looking at a really long wait or a big price drop. (This is especially true of stocks that become fads like Tesla or Apple.)
Having positions that are too big to fail: It is good to let profitable companies run and reach their full potential because companies that do well now often do well in the future. It means they have a good product or service that is attracting customers and they are executing well. But there is a point where a single stock becomes such a large part of your portfolio that it becomes too risky. I normally don’t let a position become bigger than about 5% of my net worth, figuring that even if the stock went to zero, I could recover from a 5% loss fairly quickly with the rest of my portfolio. When you’re just starting out, you might be able to suffer a 25% loss since the loss is fairly small compared to your salary and you can easily replace the money with continued investment. Know that you certainly don’t need to sell entire positions that become huge, but cut things back until you’re comfortable.
Have positions that are too small: The whole point of single stock investing is to chose companies that will outperform the markets and give you superior returns. If you spread your money out too much, even when you pick a winner it will have such a small effect on your total returns that you might as well just buy index funds. As previously stated, there are risks with individual stocks that they can fall and never recover which you won’t see with indexes, but you should still make bigger bets if you are going to invest in them than you would if you were buying stocks through mutual funds. It might be that you have mainly funds but then have a few individual stocks that are more concentrated. Or you might have ten to twenty individual stocks instead of an index fund with 1000 companies.
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Reasons to buy individual stocks
So, what are the reasons to buy indiviudal stocks instead of just sticking with funds, particularly index funds and ETFs? Here are a few:
Market beating performance: People will rightly tell you that most active managers don’t beat the markets over time. Several studies show that index funds beat most active managers over long periods of time. The argument then goes that if a professional manager can’t beat the markets, what chance do you have?
But there are individual investors who do trounce the markets. These tend to be people who have a lot of shares of one or two companies that they’ve acquired over a few decades from an initial position that just keep growing and splitting shares. Individual investors actually have huge advantages over professional managers: They don’t need to invest a large amount of money so they can invest in just their best picks without moving the prices of the stocks they’re buying. They don’t need to beat the perfornace of other funds every quarter so they can stay invested and wait through bad periods. They don’t need to invest new money that comes in right away after market surges or sell stocks to pay people who are selling shares in the fund. If an individual investor takes advantage of these advantages, he/she can succeed where most professional managers fail.
Individual stocks allow for flexibility: When you buy a managed mutual fund, you have no control over what the manager does with the money. While all funds have objectives and defined investing styles, there is usually sufficient flexibility for the manager to deviate, so you may not actually be buying a fund that will invest as you expect. You can select an index fund and know what stocks it will be buying since it just follows an index, but your choices may be limited. In particular, many of the index funds are dominated by a few large stocks. Many of the large cap funds buy the same big stocks, so you don’t have the diversity of companies that you think you do.
With individual stcoks, you can pick just the companies that you want. This means you can do things like buying equal amount of what you consider to be the best stock in each of ten or 20 areas. That’s a lot more diversification than something like the QQQs that are dominated by big tech companies. You can create a portfolio of your own choosing rather than buying what everyone else is buying.
Individual positions allow you to delay paying taxes: With an index fund or managed fund, if the fund sells shares at a profit, you’ll need to pay taxes on the gain even if you roll the money back into the fund. If you’re buying individual stocks, you can delay sales by being a longterm investor and rarely selling. When you do sell, you can also sell losing positions first while letting your winning positions continue to grow untaxed or sell losing positions against gains and have the gains cancel out. You will need to realize profits sometimes, but you can delay them for years through proper portfolio management.
Attend shareholder meetings: If you own a fund, the managers get the invitations to go to the meetings. As a shareholder, you can go yourself to the company annual meetings and sit with other investors and hear about your company direct from the CEO and other officers. Often there is a call-in number as well for when the meeting is being held in a location that is too far to make the trip.
Give-aways: Many companies give away coupons for their products and other items. I don’t know if the fund managers just keep all of these with a mutual fund, but you certainly won’t get them as a mutual fund investor. Yes, this is a silly reason for owning a stock, but it can also be a neat fringe benefit.
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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.