Some people ask me if they should invest in individual stocks as opposed to investing in an equity fund, where a portfolio manager is responsible for deciding which stocks to buy, sell, and hold. As with everything, there are advantages and disadvantages of investing in individual stocks
Here are my thoughts…
There are those who invest in individual stocks with a keen desire to invest the time and energy necessary to understand the companies in which they invest, analyze their historic performance and forecast their future growth path.
And then, there those investors who are looking for some thrill and excitement. They want to have a little fun with their portfolio and they think stock picking is the way to outsmart the market. To them, it’s like a game: how much can they outperform the market?!
Risks of investing in individual stocks
But individual stock investing is risky. Much riskier than investing your money in an actively managed mutual fund. And significantly riskier than investing in a passively managed fund.
Here are some of the reasons for this extra level of risk:
- You need to create a diversified portfolio to increase your chances of long-term financial success. As the saying goes: don’t put all your eggs in one basket. To do that, you need to buy at least 40 individual stocks – which takes time and expertise.
- You need to monitor your stocks regularly to make sure your “winner” doesn’t end up being a loser.
- You need to avoid becoming emotionally attached to your stock picks. A great way to do that is to use stop-loss orders to limit your risk.
- If you trade your stock portfolio frequently, you can end up paying high brokerage fees.
Of course, this doesn’t mean you can’t ever invest in an individual stock, but you should do so only when certain safeguards are in place. More on that below.
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Advantages and Disadvantages of Investing in Individual Stocks
But first, let’s take a closer look at some of the reasons why you shouldn’t invest in individual stocks:
#1: It takes a lot of time, expertise, and objectivity.
Investing in individual stocks without the time or training necessary to perform basic research and analysis rarely leads to success. Analyzing stock picks is generally reserved for trained fund managers, brokers, and financial analysts at large institutional investment firms. These people have cutting-edge investment tools at their fingertips. They also have the time and know how to read earnings reports, SEC filings and other things like that.
Plus, and perhaps most importantly, institutional investors get the information they need about a company to make investment decisions before that information becomes available to the general public. And once vital news about a company is released, they have systems in place to instantaneously react to it. In other words, as an individual investor, the cards are stacked against you. By the time you have enough information to act, the stock price has already been adjusted by the institutional investors working within the market who know more than you do.
Another thing to consider is that many investors are blinded by emotions that prevent them from making objective buy and sell decisions. When you invest in individual stocks, it’s very, very easy to get emotionally attached to the companies in which you invest. Not only do you know a lot about these businesses, but you may also believe in them and what they’re doing. When this happens, it becomes harder to see the red flags along the way telling you that it’s time to sell.
#2. It costs more.
Every time you decide to buy or sell a stock, it’s going to cost you in commission fees. Depending on your broker, these fees can range between $3 and $8. While that may not seem like a lot of money, it can add up quickly if you own a lot of individual stocks and are making frequent trades. One big downside to this, aside from the expense, is that it may make you think twice before selling a stock in order to avoid the transaction costs. You might end up holding onto an investment that’s declining in value longer than you should be thus compounding your loss.
Related article: How I Got Started Investing
#3. There’s a greater risk of loss.
With individual stock investing, it’s extremely hard to get the kind of diversification you need to offset your losses. The biggest reason why managed funds, like ETFs and mutual funds, have less fluctuation in value compared to individual stocks is that they’re generally invested in lots of companies. So, even if the price of one stock plummets, the fund as a whole remains stable. They also have less trading activity, which keeps transaction costs low.
Related article: One Simple Step to Get Started Investing
Why you should invest in individual stocks
But what if, after all of the above, you still really want to invest in individual stocks?
Here are a couple of reasons why investing in individual stocks may be a good thing:
- You want to have some fun with your money. Hey, you might actually strike it rich with a winner like Apple! But if you want to take a chance on picking the next big winner, then limit your “fun money” to 5% of your portfolio.
- Make sure you can live with the loss if the “winner” you choose ends up failing. And keep the bulk of your portfolio invested in diversified mutual funds and ETFs, which are less risky.
- For some investors, buying individual stocks helps to keep them engaged, motivated, and focused on their wealth building goals.
- Investing is, after all, a long and slow process. Trying to outpace the market a little bit by picking your own stocks can help spice things up a bit.
Personally, I’ll find my thrills climbing mountains. But I get it (kind of) if that’s not your thing.
In other words, if you have the means and the motivation, you should approach individual stock investing as you would an entertainment expense, not as an investment. There will always be advantages and disadvantages of investing in individual stocks. If your individual stocks turn into winners, great. If not, then you can view it as a fun learning experience. Otherwise, you should stick to mutual funds and ETFs since they offer much more security and a better return on investment for your time and money.