This article is by staff writer William Cowie.

Even if you’ve never made an overt decision to invest in the stock market, stocks form the foundation of your retirement investing. (At least if you’re like the vast majority of Americans, they do.) That’s because your 401(k) — or equivalent employer retirement plan — is only allowed to invest in mutual funds, and most mutual funds invest in the stock market.

If you are investing through a Roth IRA account, though, you do have options. You can invest in mutual funds (of which index funds are a subset) or you can buy stocks individually. Does that mean you should buy individual stocks for your Roth IRA?

Unpredictable, to say the least

Many people own stocks outright. Some acquire stock in their employers at favorable terms, either through stock options or directly. Microsoft is a famous example of a company which made thousands of its employees millionaires through company stock ownership. Not every company is Microsoft, however. Enron is a famous example of how that benefit blew up (rather spectacularly) in the faces of thousands of employees.

Many buy stocks not associated with their employers. My millionaire-next-door neighbor, Jim, has invested in individual stocks all his life, because he hates the thought that mutual fund managers will take money from him for doing something he can do himself. (Not surprisingly, he also does his own plumbing and related home tasks.) On the other hand, another friend of mine (who shall remain nameless) regularly loses money buying individual stocks, so he says he has stopped doing that. At least until the next no-lose deal comes along, I suspect!

You can see that investing in individual stocks can work — or it might not work. As with most things in life, it’s the dramatic collapses which grab the headlines (Volkswagen and Valeant being two of the most recent) while the quiet successes (like Jim’s) go largely unreported.

What does it take to succeed at buying individual stocks?

More importantly, should you do it? (For most people, the answer is no, by the way.) To answer that question for yourself, though, you need to think about about these five things and decide:

1. How to handle risk

If you had put all your money in Microsoft stock in the ’80s, you might have become a millionaire. However, if you put your money in Lotus or any of the other high-flying tech stocks of the day, you would have lost money. More recently, Facebook stock turned out to be a winner and Twitter ended up a loser. How do you know which companies will do well, and which won’t?

You don’t.

There’s a word for our universal inability to predict if a company will turn out to be a winner or a loser. It is called “risk,” i.e., the company you choose may hit it out of the park, or it may be hit out of the park in tatters.

This is your retirement money we’re talking about — do you really want to risk losing it (or even a portion of it)? Probably not.

2. How to diversify if your income is limited

The number one way to reduce investing risk is by diversifying, i.e., not putting all your eggs in one basket. You achieve diversification by creating a portfolio of stocks. That in turn requires buying many different stocks. That way, if one goes down, another goes up … and with any luck more go up than go down.

Buying many different stocks, though, requires a lot of money. The money that you and I are socking away in a savings account every month is usually not enough to build up a decently diversified portfolio.

3. How to acquire the requisite knowledge

Like most profitable things in life, there is a lot more to buying individual stocks than meets the eye. So, you have to know what you are doing. That knowledge does not come by osmosis; it takes an intentional effort to acquire it. You need to understand:

  • Stock investing in general — things like technicals and fundamentals
  • How to research individual companies as potential investments — how to read technical charts and/or financial statements

Investing in individual stocks also requires stomaching a certain amount of risk (again, nothing for nothing). Another good antidote for risk is knowledge, but not everyone is inclined to study something as esoteric as stocks.

4. How to accommodate your needs

Time is money. If you do your own plumbing, you might save money — but every fix will take a bite out of your time. (And buying all the right tools will take some up-front investment.) The same is true of investing.

Despite what index fund apologists say, it is possible to outperform the S&P 500. Thousands of people do it consistently. However, acquiring the knowledge mentioned in the previous point takes time … and it also takes time to keep up with it.

Couple watching movie at home

Unfortunately, most people have lives to live, lives which consume all or most of their time — jobs (with commutes), kids, hobbies, extended family, social activities and a whole host of other things. What time is left is usually needed to recuperate and hang out with friends. That is why most people have their oil changed at a lube shop and their plumbing done by someone who charges more than a doctor … and why they leave managing their investments to a computer tracking an index.

5. How to ignore the talk

We are humans, and we live in an age with an incessant barrage of news and speculation about anything which interests us. If you make the time commitment to invest in stocks, you of necessity expose yourself to a lot of chatter about companies and their stocks.

Another thing about human nature is that it’s difficult not to get excited when everyone else is excited and depressed when everyone else is depressed. Generally, that makes for bad investment decision-making. For example, when everyone was beating up on Facebook after its IPO, that was the time to buy. Not many people can buy when the noise dictates selling.

It takes a certain amount of intestinal fortitude to set a course and stay with it, ignoring the ruckus that is always surrounding you. Warren Buffett, the grand master of individual stock investing, calls it “the art of doing nothing.” Not many people have the temperament to master that art. Until you can, you are opening yourself to habitually making mistakes when picking companies to buy and sell. Can you walk the walk and ignore the talk?

If the foregoing points make you depressed about investing in stocks, take heart.

There is a viable alternative

The biggest reason to eschew investing in stocks individually is there is a better way: You can buy mutual funds in general and index funds in particular. Those funds invest in stocks, but you end up in a better place because, compared to the five points above mutual funds and index funds…

1. Effectively minimize risk

Index funds achieve the greatest diversification possible — you’re buying the entire market, as it were. Granted, you will forego the glamorous gains of the Microsofts of this world, but you will also avoid the pitfalls of the Volkswagens and Enrons.

Ever since their inception, mutual funds have proven to offer a decent return with minimal risk. The only risk they can’t protect you from is when the entire market crashes, but time has proven that if you simply stay the course, each subsequent correction will end up leaving you in a better place than before.

2. Don’t require a lot of money

Anyone can invest in a mutual fund, even with the small amounts we set aside every month for our retirement.

3. Don’t require a great deal of specific knowledge

You don’t need any, really. Simply pick the biggest index funds around and you’re set.

4. Don’t require a lot of time

All you need is 20 minutes when you get started. Then you automate everything and forget about it.

5. Effectively eliminates the talk

You don’t need to pay attention to what anybody says. Nothing allows you to master the art of doing nothing like automating your index fund investing.

Some people are simply too geeky to allow other people to do their investing for them. (Don’t ask me how I know this.) For the other 99.9 percent of us, simply setting up your automated index fund investing program is the most efficient way to tap into the miracle of compounding. Even the illustrious Mr. Buffett said so!

Are you interested to buy individual stocks? If so, how do you address risk, diversification on a budget, knowledge, your needs, and the chatter about individual stocks? Is there another way to strike an acceptable balance other than with mutual and index funds?

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