Baby Steps For Individual Stock Picking

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corn in iowaOne of the most regular questions I get asked is how I feel about individual stock picking. Should a good investor have individual stocks as part of their portfolio and, if so, how do they fit? From my perspective, individual stock picks are fine as a small part of an overall portfolio. Here’s my reasoning behind that, as well as my strategies for using individual stock picking as a small part of a portfolio.

To explain things, let’s use my own investment portfolio as an example. My primary goal with my non-retirement investment portfolio is to buy a piece of land in the country, build a wonderful house on it, and allow a sizeable percentage of it remain forested. Where I live, in Iowa, you can find such land, particularly in the northern part of the state, at a reasonable price.

Looking at a portfolio as a whole
The first question you need to ask yourself is why do I want to invest in individual stock picking at all? Individual stock picking is an extremely high risk/high reward form of investment and it requires some research to stay up to date on it – you can’t drop in your cash, sit back, and expect to be successful at it. Thus, your investment goals must be in such a state that you’re comfortable risking a slice of your investment to chase big gains.

Does this mesh well with my goals for investing? What happens if I see a loss in my portfolio? The short answer is that the dream moves further into the future or we settle for something smaller, more likely the latter because we both want to be young enough to enjoy it when we can afford it. What happens if I hit a few home runs with my individual stock picking? We can buy sooner or buy something greater, like a horse stable. This portfolio, in other words, can actually sustain a sizeable fraction in a relatively risky investment like individual stock picking.

On the other hand, let’s look at a retirement portfolio. This portfolio can’t afford losses, as it means a lower standard of living in retirement or a later retirement date. Big gains help to a degree, but they mostly help pay for extravagances and gifts to family. Thus, a retirement portfolio shouldn’t include a risky piece like individual stock picking.

What should make up the less-risky portions of a portfolio? Broad-based low cost index funds of stocks and also some bond investments, in a nutshell. The index funds are more volatile than bonds, but have a long term positive track record that exceeds bonds. In both cases, the investment has an incredibly strong likelihood of increasing at a greater rate than inflation over the long term, whereas individual stock picks can be highly variable and can’t hold any such promise.

Individual stock picking as a piece of a larger portfolio
The first step is to determine how big of a slice of your portfolio you’re willing to contribute to individual stock picking. I am very conservative; I would be hesitant to have more than 25% of a portfolio in individual stocks no matter what unless the goal was purely wealth building and there was no direct use for the money in the long run.

Once you’ve determined how much you’re willing to invest in individual stocks, learn how they work. So far, I’ve found Jim Cramer’s Real Money to be the best guide I’ve read on individual stock investing in the modern world.

Getting started Cramer recommends having a bare minimum of 5 stocks in your portfolio and a bare minimum of $500 in each stock to start with – that’s a total of $2,500. I would recommend starting with more than that for cash, perhaps $1,000 in each stock.

What broker do I use? I’m far from an expert on various brokerages, but I will say that I have used E*Trade with some success, though their fees are a bit high (I discuss how fees work below). I have heard positive things about Scottrade and their fees seem much more reasonable ($7 per trade). Generally, the higher the cost, the more hand-holding and research tools the brokerage provides. In general, most of the major online brokers are quite reputable – do a bit of research and you’ll be fine.

How do the fees work? In a nutshell, here’s E*Trade’s fee chart; I have less than $50,000 in assets and do less than 30 trades a quarter, so the cost of any buy or any sell is $12.99. So, let’s say I had $3,000 and I wanted to buy 30 shares of a stock that’s at 100; I have to actually pay $3,012.99 to get those shares. The shares go up to 120 and I decide to sell them; I actually only get $3,587.01 from the sale. So instead of a 20% return, my actual return is 19.1%.

Ouch! How can I avoid being stung like that? There are two things you can do. First, when you select a brokerage, carefully investigate the costs – know what you’re paying for and why. Second, be careful when you make trades – active trading will eat you alive in fees unless you’re sure of what you’re doing. Time your buys so that you can minimize the fees you have to pay; for example, let’s say you want to buy $500 worth of five stocks to start with, then put in another $100 a month into each stock. That means that you’ll be dinged for five trades every single month. A better strategy would be a round robin approach – put $500 each month into one of the stocks. That way, you’ll only be dinged for one trade and after five months, you’ll have more in your portfolio than you would have otherwise.

What I’ve found is that individual stock picking can be a lot of fun, but it’s risky and challenging – bordering on too risky for my tastes.

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17 thoughts on “Baby Steps For Individual Stock Picking

  1. I intend to stay away from stocks. I know this flies in the face of all conventional wisdom, but I am very anti-corporation. Just read the newspapers everyday. I am sick and tired of CEOs whose annual salaries could support a small country, while their workers are struggling to make ends meet. I refuse to be part of this system. I like the blog you did in the past about treasurydirect.gov. While the government does not always operate the way I like, I think I will be investing in T-bills and bonds. The older I get, the more I distrust big business.

  2. Lori, be careful with that strategy. It is very hard to build wealth over time with only bonds (in any form). They just don’t pay as well, and that will kill your retirement.

    What you can do on the other hand is pick and choose the companies you invest in. Instead of a broad index fund that covers the good and bad companies, build your own diversied portfolio. It will take a lot more work, but you can get similar gains without sacrificing your morals.

    For instance, you want a piece of the cheap retail market? Go for Costco instead of WalMart, and go for some of the new B corporations instead of the more traditional ones.

    Basically, you can have both, a retirement and a clean conscience.

  3. Thanks for the reply, Chris. I am interested in hearing more from people who try to invest with a social conscience, and not just for their own bottom line.
    I have owned stock in companies that I have worked for in the past, and I have always been extremely disappointed in the annual shareholder’s meetings in terms of what the company puts on the ballot for voting and how they limit what questions can be asked by shareholders. Large corporations are the least democratic organizations that I know of.

  4. Good post. I’m a huge fan of individual stock investing and am glad to see someone like yourself who considers themselves conservative still supports it.

    However, if you don’t want to worry about fees, use Zecco.com. If you want to dip your toe into the water and see what it’s like to buy individual stocks, then start with just a single share! Having just started to invest with real money, I have a portfolio of seven stocks, each owning literally one share. I am learning great lessons, and haven’t paid one cent in fees.

  5. There are plenty of stocks that you can “set it and forget it.” In fact, most active traders tend to underperform their “buy and hold” peers.
    Don’t listen to Cramer. Listen to Buffett. And you can always pick up some Berkshire.

  6. Owning individual stocks takes a great commitment of time and effort and risk tolerance. I used to own a lot of individual stocks and spent hours reading reports, analysts, opinion pages, etc. It was a waste of time. I was competing against giant investment banks with Cray computers and armies of analysts working 18 hour days with billions in funds to influence markets. In my opinion, your best bet in the market is to buy broad-based index funds with very low fees and hope to float along with the broad trends.

    I ended up cashing out all of my stocks and making a nice 30/30/30/10 split between Vanguard domestic index funds, European/Asia Pacific funds, bond funds and REIT funds. I check it once a week to make sure there’s no surprises, rebalance twice a year, and reinvest dividends/gains. It has saved me time, money, and headaches and my returns are better now that I’m not trying to out-Jim-Cramer Jim Cramer.

    And Lori, I hear you on the social conscience, but treasury bills are going to support Halliburton, for example – some of that US debt is being incurred to fund a war. I divested my Wal-Mart stock holdings a long time ago because I don’t like what they are doing to their employees, but I fully recognize that my Vanguard index funds hold at least a few virtual shares of Wal-Mart in them. It’s tough to invest in any market with a social conscience unless you’re willing to have a little cognitive dissonance in your life and accept that somewhere, somehow, some of your money is going to bad people doing bad things. It’s admirable that you consider it, though. For a long time I would have invested directly in Landmines ‘R’ Us if the returns had been good enough (fortunately my mindset changed).

    I work as an audit consultant for a lot of Fortune 500 companies and I agree 100% – if most investors knew what was really going on in these places they would be uneasy. Maybe nothing technically illegal, but there’s a LOT of pressure to “gently nudge” numbers. Invest in the market at your own risk and recognizing the nature of the beast!

  7. There are plenty of mutual fund products and vendors out there that tailor the fund to whatever set of beliefs you may hold, from environmental activism to social conscience to religious character. However, I have moved away from being an active investor, and think that if you are concerned with personal wealth creation, then your conscience should be directed towards your spending and consuming habits and your investments should be directed towards broad index funds. If enough people don’t buy from wal-mart or another company that you find objectionable, then the market will drop those companies from the index as they fail. Meanwhile, you will take some of the profits of those companies and re-direct it through your spending to things you consider more worthwhile.

    I’ve stumbled across a book called “Index Funds: The 12-Step Program for Active Investors” by Mark Hebner that is pretty good at highlighting the pitfalls of active investment. Take it somewhat lightly because his primary business is selling index fund products, but I think the info inside is actually pretty good. It has a positive blurb from John C Bogle on the cover, so that’s gotta make a few people around here excited ;)

  8. there is an easy to understand alternative to picking stocks or mutual funds. DRIP stocks (Dividend Reinvestment Stock Plans) I’m surprised it’s never been mentioned here as it’s the frugal mans choice. You start with 1 share and you can add to it in small amounts, as little as $25. The dividends get reinvested and buying fractional shares isn’t a problem. Unlike buying individuals with loads of risk your buying large blue chip stocks with a long history of raising dividends. The only risk is in getting lazy and not getting your quarterly $50 cheque. The best part is the stocks can often be bought commission free, simply get a friend to sign you over one share.

  9. Wow, thanks for all of the input. I do appreciate it.
    This begs the question – is there a way to become financially secure without stocks or bonds? I suppose real estate is an option.

    I think I need to sit down and really think about what my goals are. While I desire a certain level of financial security, I am not sure if chasing wealth is what I am all about. How much is too much, and can one ever have enough? Hmm, maybe these are thoughts for another post.

  10. Stock picking won’t get you anywhere. The best example of this is with the recent CNBC stock picking contest. The winner ended up being a waitress who never owned a stock in her life. Although no one will admit to it, it is believed that there were some people who do stock picking for a living that were in the competition too. Save your money from commissions and buy low cost index funds. Vanguard’s Total Stock Market (VTSMX) is the simplest way to get total diversification in the domestic market for the lowest cost.

  11. I would select your investment style before you start investing in stocks. For example are you going to select growth stocks or value stocks. I have never read any book’s by Cramer as I don’t care his hyped TV show. I would look towards investors such as Peter Lynch, John Neff and Warren Buffet. Buy and hold is the best way to make money in the market.

    I agree with the reader on DRIP’s as a great way to start investing in stocks (see my recent story on DRIP’s. Also I have a article on moving my account from Scottrade to Zecco and pay $0 on stock trades.

    I use index funds for 80% of my portfolio and the rest is invested in high quality dividend stocks that I will use for retirement income.

  12. I have parents and parents-in-laws in their 70′s and 80′s and they think their wealthy when I ask them. They made $$ way beyond what they came from, they think and believe that. They all have less than $200,000.00

    My 80 year-old mother-in-law lives on very little but has investments worth $200,000.00 and swears she’ll never touch them and only takes the required minimum distribution that she has to. She is completely happy and does everything she wants in life.

    She thinks she’s wealthy compared to what she was raised on as do a lot of folks in that age group. They all have stories that are pretty incredible to listen to about how they grew up and what their parents did to survive, etc.

    It’s definitely worth planning and visualizing what life looks like to you at 70, 80, etc. if you’re reasonably healthy at that point. Where do you live? How much do you travel? How much of a cash burn rate do you want/can you afford? Etc.

  13. Hey Lori…

    Have you ever thought about a socially responsible index fund like say VFTSX from Vanguard?

    It’s a good way to dip your toe in a mutual fund that follows a environmentally and socially friendly fund. It doesn’t include ALtria, Wal-Mart and others. It trades at like $9.91 right now and has a small .25% expense ratio.

    Just a thought…

  14. I will look into it Luke. Thanks!

    Bill – I know an elderly person with a net worth around $200,000. She has a monthly income of $1500 (pension and Social Security). She has no debt. She considers herself well-off. She recently moved into a very nice assisted living facility. She will be able to afford this for about 5 years. She is 83 and has some health problems, so she does not look beyond the five years. She lives very comfortably. She never invested in the stock market. All of her money have been in CDs that roll over.

  15. Several years ago, I read the most amazing story about a woman named Anne Scheiber. She didn’t know anything about investing in stocks but, as an IRS auditor, she knew it was the only way she knew how to get ahead.

    She had been with the IRS for many years and was getting passed over for promotions because she was a woman and becuase she was Jewish. When she retired back in the 1940s her pension was something like $3,000.00 per year.

    Anne became the poster child for investing. She saved five thousand dollars and invested it all in the stock market. She invested the money in companies she believed in and understood. Anne lived on a shoestring socking away every penny she could into the market.

    When she died in 1995, her portfolio was worth 22 million dollars. Anne gave her entire fortune to Yeshiva University – a college she had never visted – and specifically designated the money to help educate needy young women.

    Buy companies you understand, reinvest the dividends, and hang on to them, like Warren Buffet says, “forever”.

    The rewards are astonishing.

  16. Any thoughts about Zecco? (www.zecco.com) A number of personal finance blogs have mentioned switching to them for stock trades due to their very low fee schedule (cost: $0; max 10/day, 40/month, $3.50 for each after that).

  17. Picking stocks is a fool’s endeavor. Keep costs as low as possible and allocate your assets in index funds that mean you buy the whole market. Pick which markets you invest in based on your time in life and tolerance for risk.

    Please read The Four Pillars of Investing, William Bernstein, or A Random Walk down Wall Street, Malkiel.

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