Why Should You Buy Individual Stocks Instead of Just Buying Mutual Funds?


The Bogleheads’ Guide to Investing is truly a great book and one that you should read if you want to get involved in investing and to improve your financial life in general.  It includes information on mutual fund investing, budgeting, and what kinds of insurance you should have.  It also includes a lot of good information on research that has been done showing things like that the average investor would be better off just buying index mutual funds than managed mutual funds since most index funds outperform managed funds over time.  Likewise, it favors investors using mutual funds instead of individual stocks for the same reason – on average, most investors do better just buying index mutual funds than they do buying individual stocks.Now I have always been an individual stock (and bond, and warrant, and convertible) investor, probably because my father was an individual stock investor.  Of course, I started before index funds really existed.   Mr. Bogle started Vanguard and introduced the world to index funds back in 1976 with the start of the Vanguard S&P 500 Index fund, but back in 1984 when I started investing the fund was relatively small and there was little talk of index mutual funds, so I hadn’t heard of it.  I did buy a few closed-end mutual funds during that period, such as Tri-Continental Corp and Adam’s Express, but I was mainly invested in several individual stocks, taking up positions of 100 shares at a time.

There are really two purposes to a mutual funds.  The first is to allow small investors to spread their money out over several stocks, and thereby eliminate the risk that they would be substantially hurt should one of the companies in which they invest have an issue, for example, if the CEO defrauds the company or a company grossly misreads the markets and ends up closing down a lot of stores and going bankrupt.  I’ve had both things happen since I’ve been investing and I can affirm that you effectively lose your whole position when they do occur.  If you had your whole retirement savings in thee companies and one of them has an issue like this, you would see 1/3rd of your money disappear in a day.  If you have only a few stocks and even if nothing big happens, but a company stock simply flounders around for ten years and goes nowhere, you still have missed ten years of potential appreciation on your money.  You should have seen your money at least double in that time period, meaning you would have half as much money at retirement as you could have had.  This is why individual investors need diversification.

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The second reason for investing in mutual funds is to have an expert investor manage your money for you.  You pay an expert to do the research and pick the stocks for you, decide when to invest, and keep tabs on things.  You have fund companies like Janus who claim to have all sorts of insight and access to information that will allow them to make the best picks and do far better than you could do investing alone with your limited resources, or so the sales brochure says.

The trouble with this second idea is that professional money managers with managed mutual funds do not outperform the markets on a regular basis.  Various studies have shown both that investors would do better using index funds or simply throwing darts at a dart board much of the time.  This is because managers don’t outperform the markets with their picks or their market timing, instead maybe matching the performance of the markets at best.  You then do worse than the markets in a managed mutual fund due to the trading and research costs, especially if you include the fees they charge each year whether they beat the markets and make you money or not.


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So going back to the first question, why would anyone buy individual stocks instead of just buying index mutual funds?  If the pros can’t beat the index funds, what chance would an individual investor have?  The thing is, while there are few if any managed mutual funds that beat the index funds, there are individual investor who do so, and there are enough of them to make it more than just a fluke.  In fact, Warren Buffett, who has been the richest man in America at various times in the past, made his fortune by picking individual stocks.

The secret lies in the way you buy individual stocks, taking advantage of something an individual can do and a professional money manager at a mutual fund cannot – concentrate your holdings in a few great stocks and hold for long periods of time.

Concentrate your holdings.

By concentrating your holdings, while subjecting yourself to the single-stock risk discussed earlier, you are giving yourself the opportunity to make a real significant gain when you are right.  Professional money managers can’t do this because they have so much money to invest.  If they tried to put all of their money in just a handful of stocks, they would end up driving the price up and owning the companies.  An individual can buy 500, 1000 or even 2000 shares without the market even noticing.

If you own a large position and the CEO does jump town for Rio and the company goes bankrupt, you might be out $10,000 or $20,000 by doing this, but if you have a company that doubles a few times over a ten-year period, you can make $50,000 or even $100,000 if you have a lot of shares.  One success makes up for a couple of failures.


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Hold for a long period of time

  A professional money manager is constantly having her performance compared with the markets and other money managers.  Some managers even go out and buy whatever stocks did well right before the quarterly or annual report comes do to make it look like they had all of the hot stocks during the period. This adds to cost and means that they are buying stocks when they have already gone up in price.

Individuals can buy shares in a company and then just wait for the company to grow and do well, eventually catching the eye of the markets.  I sat on Home Depot stock through the late 1990’s and early 2000’s while the stock went nowhere.  Eventually they traded out CEOs and started to grow again.  Over the last few years, they have gone from $18 per share to about $190, which means that over the 20-year period they have returned about 12% annualized, compared with an 8% return for the S&P 500. If you were to look at my performance on that stock back in 2009, you would have only seen the stock go from about $18 to $20 over the 12-year period and I would have probably been fired if I were a fund manager.  It is only in the last ten years that the stock has greatly outperformed the markets.

So the bottom line is that individuals would be just fine buying only index mutual funds and the vast majority of investors should do so.  You’ll outperform managed funds and earn a good return on your money.  Every investor should have index mutual funds as the core holdings in their 401k plans, IRAs, educational IRAs, and other places where they really need to make sure the money will grow over time and be there when they need it.  Some investor, however, could also be well-served to add a couple of individual stocks, bought in high concentrations (at least 500 shares but never consisting of more money than one would be willing to lose) and held for long periods of time to their investment accounts outside of their core mutual-fund holdings.  I think there is still a role there for individual stocks.

New to investing? Want to learn how to use investing to supercharge your road to financial freedom?  Get the book: SmallIvy Book of Investing: Book1: Investing to Grow Wealthy

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

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.

Is This the End for Stocks (or Just the Start of Something Big)?


There was an interesting article in The Wall Street Journal on Friday about how companies are slowing down stock buyback programs.  This is one way in which companies return money to shareholders – they use some of the extra cash they are generating to buyback shares, taking them out of the market and reducing the number of shares out there.  Theoretically, this makes the remaining shares more valuable, thereby rewarding shareholders.  I’d say that the jury is still out on whether this actually works.

One thing share buybacks definitely do is to increase the earnings per share since there are fewer shares out there even if earnings remain the same.  Because many investors use earnings per share to judge how well a business is doing, reducing the share count might lead to additional investments and higher share prices.  I always look for a string of earnings per share increases when evaluating a stock.  That said, seeing EPS increase just because the share count is being reduced is questionable.  Kind of like saying that your car is faster because you’ve installed smaller tires that make your speedometer read fast.

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The main reasons that a company buys back shares are to 1)reduce the dilution caused when they issue shares and options to employees and executives and 2) because they don’t have good places to invest the money, so they figure they should just reduce the number of shares out there.  It appears that the latter has been true for the last several years with share buybacks reaching very high levels from 2011 to 2016 as a sluggish economy has caused many corporate boards to hunker down and wait for conditions to improve.  This meant that share prices increased, but the overall economy was relatively stagnant.  From the Journal: “The postcrisis surge in buybacks has been frequently cited by stock-market bears as a sign that the market’s eight-year advance has been driven more by financial engineering than by long-term growth.”

Since the election of Donald Trump and the proposed tax cuts, along with cuts in regulation, companies are thinking that the economy may pick up and they may be able to expand again.  In particular, rollbacks in regulations associated with The Affordable Care Act, such as the requirement that businesses with more than 50 full-time employees provide health insurance, may lead to growth since companies could hire more workers and have more workers full-time (or even overtime) without incurring a big change in labor costs for passing from 49 to 50 workers.


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Why this should be interesting to investors is that the current stock market rally, which has gone on for about eight years now, may be able to continue despite the relatively lofty evaluations.  Price to earnings ratios will eventually return to historic averages, but that can occur by stock prices declining or by earnings increasing.  If companies expand and see earnings increase, current stock prices may become more justifiable, allowing share prices to hold their gains and maybe continue on for a while.  The end may not be as near as prognosticators are predicting.

That said, stock prices may already reflect a lot of the expected growth, meaning that as earnings increase due to sales increasing, instead of due to stock buybacks, share prices may remain stagnant since the good news is already priced in there.  We may even see the scenario where earnings increase, but not by as much as investors were expecting, so share prices may actually decline.  The lesson, as Yogi Beara used to say, is that predictions are always hard, especially when they are about the future.


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So what is the investor to do?  The answer is the same as it always is:  Invest money that is not needed for the next five to ten years and invest regularly.  It is hard to say where the market will be in three years, but in ten years it will very likely be up.  Over long periods of time, stocks will perform better than CDs, bonds, or any other interest-bearing asset.  This is because the stock investor is taking more risk than the income investor and prices are set to reward investors accordingly.  If there is a decline as share prices reset from the big run-up we’ve seen, it will just mean that there will be bigger profits to gain when share prices rebound to current levels and beyond.

New to investing? Want to learn how to use investing to supercharge your road to financial freedom?  Get the book: SmallIvy Book of Investing: Book1: Investing to Grow Wealthy

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

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.

What Financial Advice Would You Give Yourself at 16?


For most people, the start of their financial life is probably around 16.  That is when you can get a job, you start thinking about larger purchases like cars (and car insurance), and you’re starting to handle money a lot more since you’re going to stores on-your-own.  You’re probably given very little financial advice at this point, or maybe you’re given bad financial advice like about the wonders of credit cards or car payments.  Maybe you’ve looked over your parent’s shoulder at tax time and been told of how important it is to keep a mortgage payment so that you have that interest deduction.

Unfortunately, most people don’t get much financial advice from their parents, plus much of what they do get is wrong.  This is one of the reasons that we have so many issues with debt and bankruptcy in our society.  I expect this situation to get a lot worse as the Babyboomers and Generation-X get to retirement age but don’t have anywhere near enough saved up.

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So looking over your life now, knowing what you’ve learned, what advice would you give yourself related to money at age 16?  Here are a few things I would say:

1.  Start an IRA today.

I didn’t have a regular job at a fast food restaurant or anything while I was in high school, but I did do things like mow lawns and maintain yards for money.  I’m not sure what I spent that on back then, but as soon as I had earned income, I could have put the money in an IRA.  Starting at age 16, it would be worth about 512 dollars for each dollar I invested.  For example, $1000 invested then would have been $512,000 at retirement age.

2.  Don’t buy bonds until you’re at least 55.

Bonds offer stability when the stock market declines, at least most of the time.  For example, in 2008 when the stock market fell about 40%, bonds actually increased a couple of percentage points.  The trouble is that over long periods of time, stocks will return between about 10 and 15%, where bonds will return between 6 and 8%.  That means a portfolio of stocks will double on average every 5-7 years, where bonds will only double every 8-10 years.  I’ll take the wild ride for the higher gains any day, so long as I have 10-15 years to give stocks to recover from any declines and slow patches.

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3.  If you’re going to buy individual stocks, pick your favorite three and hold on.

I used to buy 100 shares at a time of a variety of different stocks, some of which I really liked, others I sort of liked.  Then, if the stock went up 10 dollars, I’d sell, being happy to make $1,000.  If the stock dropped by 5 points or so, I’d sell to limit the loss.  Today I pick just a few companies that I really like and buy 500 or 1000 shares.  Sometimes I may even get 2,000 shares.  I then wait for the company to grow and the stock to go up with the growth.  I don’t want to make $1,000 when I’m right – I want to make $100,000.  This might take several years, but I just hold on so long as the company looks good – I don’t worry so much about the stock price.

        

4.  Skip the car payment – buy a used car you can afford.I started out with a leased car because my father thought it was better to not need to worry about the maintenance bills.  I soon discovered that the $350 per month I was shelling out would cover a lot of maintenance.  Plus, I found that cars just don’t break down that often.  I now buy used cars for cash and have been moving up from $3000 for the first car (8 years-old), to $8,000 for the second (4 years-old), to $15,000 for the last one (3 years-old).  Along the way, I have probably saved $120,000 in car payments, which has greatly helped in funding reitrment accounts.

So what would you tell yourself at 16 years-old?

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

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.