One 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.