Why buying individual stocks is a bad idea

couple getting investing advice

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.

 

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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Lisa Aberle
Lisa Aberle
4 years ago

I do buy individual stocks, but I have a few rules. My stocks are part of my entertainment or fun money, not part of my retirement. I also only buy stocks when I have at least $1000 to invest in an individual stocks (to offset the $6.95 fee). So every month, $25 is set aside to spend on stocks, but it sometimes takes me years to buy a new stock. I thought my temperament handled individual stock investing okay (as long as I followed my rules), however, I sold my first stock this week. Although I normally have a buy… Read more »

William Cowie
William Cowie
4 years ago
Reply to  Lisa Aberle

Welcome to the psychology of investing! 🙂 If it’s any help, you have lots of company.

Call me a heretic, but selling is your enemy. I’m not alone; it has a name, and I wrote about it here:
http://bitethebulletinvesting.com/Blog/coffee-can-portfolio/

Tommy Birriel
Tommy Birriel
4 years ago
Reply to  Lisa Aberle

By second guessing ur move, u have added the emotional part to the Question of selling. I agree with what u did because u had a plan, more than most investors have. Stil though, u can let the winners roll and the losers fold by using the stop loss technique. U can determine ur stop loss (sell) point on any broker’s program. I personally use 15% but it all depends on ur risk limit. To use ur case, putting a trailing stop loss order if it drops 15%, allows for ur investment to continue gaining and the stop loss order… Read more »

Gary
Gary
4 years ago
Reply to  Lisa Aberle

The $6.95 fee to buy stock can be waived by using a zero fee online broker like Robinhood. Then you could buy without having to save $1,000 first

Beth
Beth
4 years ago

Always enjoy your articles, William! Currently, buying individual stocks is not part of my strategy. But i have a question… I keep hearing from family and friends that I should be investing in dividend paying stocks (such as banks – remember we’re in Canada though). However, said unofficial advisors are much older than I am, so I’m wondering if that’s a strategy for people who are in the income generation part of their financial journey and I should ignore it (for now) or opt for a dividend reinvestment plan. I would love to hear people’s thoughts on this one! I… Read more »

Sanjeev
Sanjeev
4 years ago
Reply to  Beth

If you need income now, may be high dividend paying index funds are good. Vanguard has such funds. But, if you do not need income now but want later in life, may be focus should be in income Growth index funds.

Personally, I am 37 years old. I go for income growth funds like Vanguard LifeStrategy Growth Index funds. Even this fund distribute dividends and capital gains semi-annually. I reinvest the dividends and capital gains automatically. As I grow older, I will move to more dividends paying index funds.

Beth
Beth
4 years ago
Reply to  Sanjeev

Thanks for the suggestion! I’ll look into it. Definitely not looking to generate income just yet.

William Cowie
William Cowie
4 years ago
Reply to  Beth

Investing in dividend stocks has worked very well for thousands. There is a particular class of dividend stocks call Dividend Aristocrats (Google the term to see who they are).

To qualify as a Dividend Aristocrat, your company has to increase its dividend every single year for at least 25 years (in other words, through at least 2 recessions). Not too many companies qualify, as you can imagine.

But having stocks that pay increasing dividends for as long as I expect to live can’t be all bad. 🙂

John
John
4 years ago
Reply to  Beth

IMO total return is a better way to go. Dividends are just a return of a portion of your investment. Remember: the value of the stock drops by the same amount as the dividend. So, for example, you go from $100 in stock and $0 cash to $99 in stock and $1 in cash (the dividend). The total value is still $100. You can achieve the same result (if you’ve held the stock for over one year) by selling shares of equal value to the dividend. Both get preferential tax treatment. By investing for a total return (vs. high dividend),… Read more »

Laura
Laura
4 years ago

I buy individual stocks as well for fun. Our real funds are in index funds in 401ks, etc. I don’t understand stocks or dividends and what I read makes me more confused. I tend to learn from experience so I opened up a Loyal 3 account with my spending money. (My husband and I each get an allowance.) so far I’ve purchased Amazon and five dividend paying stocks. I just started this summer. It’s been interesting. I add more each month as I learn about each company. I don’t get my nails done any more as we are striving for… Read more »

Tina in NJ
Tina in NJ
4 years ago

There are really only two avenues I could foresee me acquiring individual stocks:
1. Buy a fun stock as a gift for a child, I.e., One stock of Disney or a game-maker.
2. Stock award from work.
3. Inherit.

Okay, three ways. But buying mutual funds is way less work and way less stress than putting together a portfolio of individual stocks. Plus, there’s a niche fund for everything, even if you think Eastern Europe is where the real growth will be.

Emily @ JohnJaneDoe
Emily @ JohnJaneDoe
4 years ago

I get your points. It can be difficult to keep up with all of the information to research stocks effectively and to find good high-growth investments, and certainly index funds are low cost and easy to understand. I’ve found investing at least part of my money in dividend-paying stocks and reinvesting the dividends to be very effective in building my portfolio. Stocks like Altria (which I invest in) have generated regular income as well as appreciated in value. There’s plenty of information and analysis available. So I’ll make the counterargument that a portfolio that includes dividend stocks and DRIPs does… Read more »

Beth
Beth
4 years ago

Thank you! I was hoping someone would comment with an opposite point of view. Mutual fund fees are terrible here in Canada, so I’m trying to think beyond them now.

Dee @ Color Me Frugal
Dee @ Color Me Frugal
4 years ago

Great post. We do buy some individual stocks, but for the most part they are outside our retirement accounts. We max out our retirement accounts and also have a separate brokerage account for any extra money we want to invest, and in there we usually feel a little more free to invest in individual stocks if we want to.

Mom of five
Mom of five
4 years ago

Our retirement is funded (via 401k) with mutual funds from Fidelity and Vanguard. But I buy individual stocks for fun. I use the Peter Lynch philosophy of buying what I know and love (e.g. food, alcohol, household goods, retail, etc). I have never once invested household budget money that I’m not willing to lose. It’s fun for me to watch stocks and wait for just the right moment to pull the trigger. I’ve done quite well over the years and I’m definitely beating the market. And my individual stock portfolio may or may not one day be substantial, but truth… Read more »

Freedom40
Freedom40
4 years ago

While investing in individual stocks can be a fun and interesting experience, it’s definitely not the way to go from a risk perspective. Great points here. I know that I personally have lost way more than I’ve gained through individual stock investing. Now – I focus on 95% index funds and 5% individual speculative stocks. You just have to realize that this may be about the same as going to the casino. The 95% invested in “boring” index funds though – it has me positioned to “retire” at 40.

freebird
freebird
4 years ago

My retirement accounts are in open ended mutual funds but my taxable accounts are individual stocks. Risk I manage by keeping a high cash balance, diversification I force by keeping small positions and using a discount broker, and knowledge has come through experience. My strategy involves mean reversion bets on microcap names that don’t get analyst coverage and aren’t part of the famous indices. If the numbers on the financial statements look sweet to me, I take the punt. The names in my portfolio no one has heard of so it’s easy to avoid ‘chatter’. My premise is that there’s… Read more »

melinda
melinda
4 years ago

Investing in stocks is not for everyone, but that doesn’t make it a bad idea. I’ve been investing in individual stocks for 4 years now (I just turned 30) with the plan to hold for at least 20. My portfolio on Loyal3 (where there are no fees to buy and sell stocks, you can invest with as little as $10) and my current gains are 20%, even when the market has had a tough year. My strategy is to invest in MULTIPLE companies across DIFFERENT SECTORS with a strong track record (ex. DIS, APPL, BRK.B) and also in companies that… Read more »

William Cowie
William Cowie
4 years ago
Reply to  melinda

“Investing in stocks is not for everyone, but that doesn’t make it a bad idea.” My neighbor Jim did it for more than 30 years. He became a millionaire on an average salary doing that. Not a bad idea, indeed. 🙂

John
John
4 years ago

After a period of time where I bought dividend paying individual stocks, I found it too time consuming. Remember: it’s not just researching what to buy, but continuing to research everything you own in order to look for any indications it’s time to sell.

Many have done well recently with individual stocks because the market has been so good overall. A rising tide raises all boats! When the tough times return (and unfortunately, they will eventually), I feel more comfortable with the greater diversification in a broad based index fund.

As many have said though, to each their own…..

Dan
Dan
4 years ago

“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.” not necessarily true. I buy individual stocks and only individual stocks in my 401k. Expense ratios are not for me. On a $500,000+ 401k balance, even a .10% (very low) expense ratio can mean $500+/year or 2.77% of the $18,000 contribution limit, each year. I buy about 4-5 stocks a year, at an expense of maybe $40, or .008% in expenses. Think about a 1.0% expense ratio (very common)! 1/3 of your… Read more »

Mrs Lewis
Mrs Lewis
4 years ago

My father-in-law works with individual stocks, and has encouraged us to do the same. Although so many financial blogs recommend index funds! I don’t know too much about them but willing to give it a try as they seem less risky.

Matt @ Your Living BOdy
Matt @ Your Living BOdy
4 years ago

I disagree – buying stocks isn’t easy and the whole process is quite a bit of a learning experience. People say to invest in mutual funds because the average person doesn’t want to learn about a company, look at their financial sheets, and put in the time to see how they’re run. With that said, there is room for both mutual funds and stocks.

Sam
Sam
4 years ago

We buy individual stocks in our Roth IRAs, its a smaller amount of money and we are willing to take some risks. I bought Apple stock in March of 2009, it has done crazy well, because it was extremely undervalued at the time. Yes, you have to do your research and certainly be willing to tolerate a higher level of risk but I think its silly to write off this type of investing. We also use our stock buying to dabble in new industries, i.e. I’ve bought some very inexpensive marijuana industry stocks. If I spend $100 or $500 on… Read more »

connect2hcb
connect2hcb
4 years ago

In the world of investing there is perhaps no silver bullet. At any given point in time a certain investment is the best but this becomes clear only in hindsight. No one can predict what will happen in the market tomorrow but successful investors somehow manage to predict the overall trend over the long run. Being a successful investor is probably about deep understanding of economy, business, finance and accounting as well as liquidity and patience. In addition, lady luck may also have a role to play in turning an investment opportunity into a big jackpot.

Carlos Sera
Carlos Sera
4 years ago

Great post. You are absolutely correct when you estimate 99% or so. That said, I like individual stocks under the condition that you plan to hold them for life. One way to think about a stock is to call it an actively managed mutual fund and the executives are the ones making the decisions for you no different than active stock pickers do. In either event you are hiring a professional.

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