Dec 6th, 2007
Individual stocks: don’t be afraid, proceed with caution
No question about it, the stock mutual fund, particularly the low cost index fund as pioneered by Vanguard, has been revolutionary for the small investor. Combined with the 401(k) and equivalent retirement plans, the mutual fund has placed a very powerful tool in the hands of investors; its low cost and diversification make it an ideal primary investment vehicle for a wide range of investors.
Individual stocks, on the other hand, have become less popular; I have yet to see a 401(k), 403(b), or 457 plan offer an opportunity to purchase stocks in individual companies, and even when given an opportunity to purchase individual funds (say in an Individual Retirement Account or a taxable brokerage account), many are more likely to buy mutual funds or their sister exchange traded funds than they are individual stocks. Why?
The appeal of diversification and its associated lower risk tends to attract investors to mutual funds rather than individual stocks; it’s very difficult for the individual investor to buy all 500 companies in the S&P 500 but very easy for them to buy one mutual fund that tracks the index, and all five hundred companies are less likely to fail than one individual stock is to plunge a large percent.
Still, I believe there is a place in an investor’s portfolio for individual stocks. They can be had at very low cost through a discount broker or sometimes directly through the company. Some pay healthy dividends; others have a long track record of skyrocketing performance. Aside from that, it’s sometimes just plain fun to have shares in a company and to vote on stockholder issues.
How to pick stocks is a subject for future blog posts; there are tombs written on that very subject. I pick stocks of companies I know that make products I like and buy and have a history of being financially successful; others will buy stocks only in companies that meet their moral and ethical standards; still others use some kind of mechanical formula to tell them which stocks to buy.
One caveat on individual stocks; despite their appeal–and I do find them appealing in many ways–the truth is that diversification is critically important in any portfolio. So while I do own a handful of individual company stocks, the value of that handful is less than 10% of my total portfolio, and no individual stocks is more than 3% (I would say that I’d be willing to have that one stock grow to 4 or 5% but no more than that). So my bet is hedged in a diversified portfolio–my largest individual stock is about 4% of what I hold in the Vanguard Total Stock Market Index Fund, with even more diversification into the bond and international markets on top of that. My point is simply this: like credit cards, individual stocks are not evil, just another tool that can be used, wisely or unwisely, to grow your money.
