One frequent question that readers ask me is advice on whether or not they should invest in the stock of a particular company.
“Is it a good time to buy Google?”
“Should I invest in Amazon?”
“Thinking of putting some of my retirement money into Citibank shares. Thoughts?”
Almost universally, I respond to such folks like this:
Why? What do I have against investing in individual stocks?
It’s simple. Unless you are investing with money that you are literally never going to need in your life, the risk of individual stock investing is simply too high for me to recommend it, no matter how amazing the company seems. There are a lot of sources of risk in individual stock investing and they add up to too much risk for the vast majority of individuals to use as an investment strategy.
Let’s walk through some of the many issues of investing in individual stocks.
First, you’re probably behind the curve of when you should invest in a company or sell shares. By the time a piece of information becomes general public knowledge so that an individual investor can act on it, it’s already been acted upon by large scale investors and the market price has already been adjusted.
Let’s say the company issues a really good quarterly earnings report and it seems like that company is hitting on all cylinders. By the time you’re even aware of this, the value of that company’s stock has already taken off.
Similarly, let’s say some minor bad news comes out about a company and you think it’s time to sell. By the time you can even take action on it as an individual, the company’s stock will have already fallen in value.
Why? Not only do large scale investors often hear such info before you do, their computer systems react to such news instantaneously. You have no chance whatsoever of beating them.
In short, you’re not going to be able to take advantage of information in any real way, because by the time you hear about it, the company’s share price will already account for it.
Second, you can’t predict the future. You have no way of knowing if the economy is going to keep rolling like it is or if it’s going to fall off the tracks in the next two years. You have no way of knowing if a company has a great product about to come out of R&D or if they’re running on eggshells and about to collapse. You have no idea whether some other company is about to revolutionize that sector and push your company aside, or if your company’s going to be the one to revolutionize it. You just don’t know.
Investing broadly takes care of these kinds of risks. By investing in lots and lots of companies at once, you’re going to have some shares that are taking off like a rocket, some that are kind of idling in place, and some that are dropping. On average, throughout history, they’ve gone up at a pace between 7% and 10% over the long haul, but there have certainly been years during economic downturns where the average value has dropped.
On the other hand, individual shares have years where they triple in value and years where they lose all value, and as an individual, you have little ability to tell which is which. In late 2000, Enron looked like a great investment in one of the biggest companies in the world. By late 2001, it was a penny stock.
Why is this bad? In general, individual investors can’t really afford to lose their entire investment unless they’re already financially set for life and they’re investing with the excess. If you don’t have a financial fortress of at least enough to keep food on the table for yourself and your immediate dependents, you shouldn’t be taking on extreme risk with that money.
Third, it takes time to do this well. To actually invest and not just gamble based on what you heard on CNBC or from your buddy at work, you have to spend time reading earnings reports and SEC filings and other things like that. (If you’re not doing that, you’re going to be eaten alive by those who do because those who do that extra work are going to blow you away in terms of knowledge.) If you’re invested in a number of companies, that’s going to be a lot of time and effort.
Let’s say, however, that you still think it’s fine to invest in individual stocks because you still believe it’s financially prudent. There are still several mechanical reasons why it’s a bad idea.
For starters, it’s expensive to invest in individual stocks. To do this as an individual, you’re going to have to work through a brokerage. A brokerage is going to charge you for each and every buy and sell that you make. If you buy shares, you have to pay a fee. If you sell shares, you have to pay a fee.
Now, if you’re buying and selling shares in large quantities, the fees aren’t a big deal. If you’re buying $100,000 worth of shares of a single company, a $9.99 buy fee is only 0.01% of your investment. However, if you’re not dealing with such large sums of money, the percentage shoots right up. If you buy $1,000 in shares of a company, that $9.95 fee is 1% of your investment gone, right there, and then if you sell those shares later, that’s another 1% of your initial investment that vanishes. You have to get a 2% return on your investment just to break even. Similarly, if you wish to diversify your investment at all, you’re now executing multiple buys and sells, each of which comes with a brokerage fee.
Another issue is emotional attachment. When you’re investing in individual stocks, it’s incredibly easy to get emotionally attached to one company. You likely know a lot about this company. You probably believe in this company – or else why would you be investing your hard-earned money in them? When you have those kinds of connections, it’s very easy to believe that genuinely bad news is just a speed jump and minor good news is huge, great news.
Because of this, it’s often really hard to see when you should be dropping an investment in a company. Individual investors will often stick with a company long past the point where they should have sold their shares because they know that company and they believe in that company and that often blinds you to warning signs and little problems. We’re human. We can’t help but wear rose-colored glasses sometimes.
Finally, diversification is really, really hard. A single investment in the shares of an individual company is a really really risky move. You can mitigate that risk by investing in lots of companies in different industries, but by doing so, you multiply the amount of time you have to invest in studying all of those companies (the annual reports and quarterly reports and SEC filings and other materials mentioned earlier). You are also multiplying the fees you’re paying at your brokerage.
Again, as I said earlier, you could simply skip all of that work and just trust your “gut” or the advice of some guy at work. If you do that, though, you’re going to be eaten alive by those who are very informed on the subject and actually do the homework. You’re hoping your “gut” beats them. Hint: you won’t unless you’re incredibly lucky.
Now, multiply all of that effort across lots of companies.
What you’re looking at is something that’s akin to a full time job. It might be enjoyable, but it is going to gobble up a lot of time and energy. Even then, you’re still not going to be able to get ahead of the large scale institutional investors.
Given these factors, I simply can’t advise individual investors to put any money into individual stocks. Instead, I point individual investors toward index funds, which basically amount to investing in the stock market as a whole (or, as I like to think of it, an investment in capitalism in general). By doing this, you’re basically buying all the companies, which means there’s no real need to study individual companies at all. Put your actual investment money into things like the Total Stock Market Index, not into individual shares of Google.
But what if this whole thing just seems really exciting to you and you really want to invest in individual stocks? If you feel that way, I strongly encourage you to find other ways to channel that energy. Seek out a local investment club where people will discuss investing. Look for online stock picking forums. Look for stock picking contests to enter. What you’ll quickly see is that while it can be quite fun, it’s also incredibly risky, the type of risky that you don’t want to commit your life savings to.
If you really insist on investing, budget for it and treat it solely as entertainment, not as an investment. I buy things with my entertainment budget that retain value and sometimes increase in value, plus I get to enjoy them as entertainment. Treat your stock picking in the same way. If money goes in, budget it as entertainment. If it comes out, great! Use it for something useful or else just reinvest it.
If you’re not extremely wealthy and you’re thinking of buying individual stocks as a genuine part of your future investment portfolio, don’t. Instead, invest in something more diverse or, even better, clean up your financial life by eliminating debt or saving for upcoming big expenses. Your life will be in much better shape if you choose that path.