Should I Buy Individual Stocks? It’s a common question when deciding to invest in the equity markets.
My opinion is that it depends on if you like to gamble and take risks with your money. My dad would always say “the stock market is essentially legalized gambling.” I think that statement is quite accurate when it comes to buying individual stocks.
Individual stocks are risky
I have personally bought individual stocks on a number of occasions thinking I was making a good play only to later see the stock plummet into oblivion: Radice Corporation 1989 (Real Estate gone bad), International Fibercom 2000 (Dot com bust), M&I Bank 2008 (Housing Crisis).
The tax deduction gives you little solace after taking a beating and losing most if not all of your entire investment.
For some of us it takes real lessons with real losses for it to sink in. When I first started investing in the 1980’s, mutual funds and hot individual stocks were the way to go. The reality is that both were a losing game.
Mutual funds had the diversification advantage over individual stocks but their fees took money from investors another way. Hot individual stocks were hit or miss just like gambling.
The truth is that back then I knew just enough to be dangerous, which resulted in, as the quote says, “a fool and his money are soon parted.”
What makes individual stocks so risky is how quickly things can change. A major lawsuit (Pacific Gas & Electric), a change in a technology (Blockbuster), a management scandal (Enron), or a myriad of other reasons could take a profitable company and wipe it off the map seemingly overnight.
Why take the risk with an individual stock
Buying a broad market based low cost index fund is much less risky than an individual stock. An index fund provides one significant weapon an individual stock does not. That is Diversification.
Diversification means that your risk is spread out over a number of different investments. If one fails it should be such a small percentage of the overall portfolio that it is hardly noticed.
This is drastically different than the devastating impact of a failed individual stock which is often all or nothing when it comes to success.
Index funds are superior to mutual funds from a fee perspective. You can buy index funds with little or no fees. Fees are important to watch. A fund with a fee of 0.5% to 1% doesn’t sound like much but could have a massive difference of tens if not hundreds of thousands of dollars over an investing lifetime due to the lost compounding impact had those funds stayed invested and not spent on fees.
Still want to buy individual stocks?
If you are still planning to buy that individual stock know that if you put down a significant amount relative to your net worth you are effectively gambling with your financial future at stake. It’s not much different than picking red or black on the roulette wheel and hoping to get it right.
That’s not a big deal if you have money to burn, but for most of us our hard earned money should be managed much more carefully by reducing risk and increasing the odds of success whenever possible.
In my opinion if you are dead set on buying individual stocks you should put no more than 2% of your net worth in any one stock. That will help you limit your exposure but still let you enjoy buying an individual stock if you feel strongly about it and do your homework. Consider using stop loss orders to limit your downside exposure leaving enough gap to not get stopped out due to normal market volatility.