Many people say you should not buy individual stocks, and maybe they are right. Buying individual stocks is radically different from buying mutual funds. It takes a different mindset and it carries a completely different set of risks. So what is the difference?
When you buy into a mutual fund, you are buying a large number of different stocks. One of the most concentrated mutual funds you can buy is one that tracks the Dow Jones Industrial average (such as the DIA, or “diamonds”). which trades on the American Exchange. In this case you are only buying into the Dow Jones Industrial Average, which includes 30 large, household-name companies. There is also the Janus Twenty Fund that invests in just 20 stocks that the managers pick. Otherwise, you’ll probably find that a listing of the holdings in your mutual fund will cover a few pages in the prospectus (a booklet that describes a mutual fund).
Because you are buying so many stocks, your return over long periods of time will essentially equal that of the market in general, minus expenses, regardless of the mutual fund you pick. Your return will be between 8-20% before expenses if you hold for ten or more years, and if you hold for more than fifteen years, your return will narrow to between about 10-15%. There will be years when you make 30 or 40% returns, and others where you’ll lose 20 or 30%. On really bad years, you might lose 50% or more. On great years, you might make 100%.
With a mutual fund, you’re protected against a single CEO making a big mistake and causing the company stock to lose 90% of its value. You’re protected against choosing the wrong company and seeing your investment tread water while others are charging ahead. You don’t need to spend a huge amount of time pouring over annual reports or earnings sheets.
Individual stocks are different. Individual stocks routinely double in value or drop 50% in a year. If you have only a few stocks, you may see your portfolio value change by ten or twenty percent in a day. There are also times when your stocks will fall in price even though everything seems fine at the company, or continue to rise for days on end without a clear reason why. You might also see a company take on too much debt, misread the customers, or just become no longer needed and disappear entirely. This doesn’t happen with mutual funds.
So why would someone buy individual stocks? Again, most people shouldn’t. Most people who try to trade individual stocks end up making much lower returns than the markets. They buy too late, chasing the latest fads after the run-up has occurred, then hold on way to long as their stocks crash back down to earth. Then they sell out, right at the bottom, when they should have been buying.
Look at average returns, and you may see 3-4% when the market was making 15%. For most people, if they would just buy index mutual funds (funds with low fees since they just buy whatever is in a particular stock index) and forget they own them, they would do much better. In fact, everyone should do this for a portion of their portfolio if they have a portfolio of reasonable size (greater than $20,000, say).
There is a way to use individual stocks, however, for a portion of your investing that can allow you to beat the markets. This is the way that Warren Buffett and Bill Gates made their billions. You do it buy buying companies, rather than trading stocks. Rather than worrying about the price of the shares and trying to time buys and sales to make a small profit, you find great companies and buy in for the long-term. You plan to own them for the good times and the bad times as they grow and mature. Twenty years down the road, they may be paying out as much in dividends each year as you paid for the shares.
This type of investing is very simple mechanically, but very difficult emotionally. You need to be willing to sit there as your shares lose half of their value, perhaps buying more at the bottom. There may be years when the markets go up 30%, but your company’s stock sits and does nothing. The big gains are made in short bursts, with a lot of waiting in between.
Individual stock investing isn’t for everyone. But for some, it can be the path to life-changing gains. The secrets are patience, stock selection, and proper risk management. Plus control of your emotions and a willingness to buy when everyone else is selling.
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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.