It’s an age old question for those on the fence about jumping into the stock market: should I dip in through simple Exchange Traded Funds (ETFs), or through individual stocks?
Each has its own pros and cons of course, but for today we’re going to focus on the individual stock component of the subject.
While it sounds simple on the surface, investing in individual stocks can mean many different things. You could take an interest in small and aggressive technology companies or you might prefer dividend-paying blue-chips. More aggressive investors may be interested in the exciting, but possibly risky, biotechnology sector, while others will be happy to sit on a portfolio of low-risk, low return but steady utility stocks.
Before taking the leap into any particular category, you need to be aware of the risks of your investment, the limitations of your appetite for that risk, and the way your investment fits in with the overall strategy of your portfolio.
Let’s get started on this primer about how to make a decision about whether or not it’s right for you.
The benefits of stock investing
We can start with the basic notion that stocks are one of the most transparent and easy to purchase investment products in the market: you pay the share price, and you own a piece of the company.
That’s it: you have no ongoing expense ratios to contend with as you would with an ETF investment, you never have to worry about what’s happening within an index, and you don’t have to be concerned about the decisions ETF managers make on a daily basis.
You simply own your piece of the company you purchased, and can leave it at that.
The downsides of stock investing
Unfortunately, for all their benefits, stocks (and of course any asset class) also come with risks.
Even “safe” dividend stocks have risks, and the major risk is that the value of your holdings will decline to zero.
In a diversified mutual fund or ETF, each individual company’s influence on your portfolio is relatively low; if you hold stock directly, however, you face the risk of losing the whole investment. (Obviously, the counterpoint to this is that if the company you’ve invested in does really well, you can reap all of the benefits — such is the nature of concentrated risk)
It’s also not easy to build a stock portfolio that’s better than an index fund. After all, even professional money managers have a hard time with it.
One study found that for a cross-section of US equity mutual funds, over 75 percent had alphas of zero, meaning that their managers did not contribute any extra returns above what the market provided.
Another 21 percent actually underperformed the market.
In the end, the study found that only 2 percent of professionally managed mutual funds beat the market.
This doesn’t mean that you should never invest in stocks or that you can’t benefit from them.
Just keep in mind that beating the market all the time is probably not a reasonable goal. Rather, think of your stock holdings as a diversification or dividend strategy — something that can complement your existing portfolio in a positive way.
So are stocks right for your portfolio?
Two key questions that need to be addressed revolve around your time horizon and your risk tolerance.
How long do you want to hold your investments?
Generally speaking, the shorter your time horizon, the more magnified your risks become: stocks can be great performance enhancers, but they are also much more prone to volatility. If you aren’t prepared to ride through down markets you might want to reconsider investing in individual equities.
Similarly, if you find you don’t have a strong appetite for risk in general, stocks might not be a good choice. Emotional investing is the downfall of many a portfolio when it comes to performance, and it can be driven by a mismatch between a person’s risk tolerance and the actual risk of their portfolio. Make sure you have the stomach for risk before going into stocks.
In addition to your time horizon and risk tolerance, consider how much interest you have in managing your portfolio.
Investing in stocks requires time and effort. Unlike index funds, “set it and forget it” just isn’t practical when you need to research and select individual companies. If your interest level is relatively low, consider what attracted you to equities.
Was it the higher risk? Exposure to interesting sectors?
There are many alternative ways to diversify, including ETFs and mutual funds, that can help you achieve your investing goals without requiring the legwork that picking stocks requires.
At the end of the day, the answer to “if stocks are right for your portfolio” question depends on you. Make sure you know the answers to the above questions before jumping in with both feet.
Where to start
If you’re interested in adding stocks to your portfolio, there are many different directions you can go.
While all stocks carry risk, there is something to be said for investing in dividend-paying blue chip companies. These firms tend to pay regular and often increasing dividends over time, which can provide your portfolio with a remarkably powerful engine for long-term growth.
They also tend to have less volatility and more predictable returns than the more glamorous growth stocks. For many, it’s a great entry point into the world of stock investing.
Another strategy you might want to consider is value investing. Made famous by Warren Buffet, this approach looks at the financial and strategic position of a company relative to its stock price. If an otherwise strong and stable company is underpriced by the market, it might represent a more solid investment. Fundamental analysis is the foundation of value investing and involves a bottom-up investigation of the company’s financials, prospects, and operations.
Putting in some ground rules
When investing in stocks, consider implementing some ground rules to prevent your portfolio from getting too risky or concentrated.
Start with putting a limit on how much you’ll allocate to your stock holdings overall and into each company you invest in. You might also find it useful to put in stop losses on your equity positions, which trigger an automatic sale if the price falls below a certain point.
Finally, be careful about diversification. If you have a stock “budget” and you put the whole thing in one company, you might regret it later on. Instead, set a limit on how much of your stock allocation you’ll put into one company.
Seeking help
Of course, talking about stock investing is simple enough; putting it into practice is another matter. How do you know if a particular company is undervalued? What price do you pick for a stop loss? How can you tell if your portfolio is too concentrated?
Sometimes, it can be helpful to talk to someone — even if it’s just for a sanity check. A professional advisor can provide you with tips and insights into how to start and whether you’re on the right track.
Finally, remember that stock investing is a process rather than an endpoint: the more you learn, the more you’ll want to find out — and it’s a process that takes time and practice. So, if individual equities sound like an interesting addition to your portfolio, take your time and start small.
You may not become the world’s next Warren Buffet, but you can very well build a formidable portfolio that will work for you over the long haul.
Written by Anna B. Wroblewska for WiserAdviser
