Finance, Investing

Should You Invest in Individual Stocks? Probably Not.

 

I first started investing in stocks when I was 18.

Like a lot of young men, I thought I was smarter than “the Street”. What were my investment decisions based on? Hunches. Sometimes I was right, often I was wrong, but I did not become a millionaire overnight as I sometimes daydreamed.*

The following flowchart is something put together to help you decide whether or not you should invest in individual company stocks. Index funds, ETFs, mutual funds…I’m not including any of these in the decision tree because I heavily advocate using them to help you retire early and become financially independent. The truth of the matter, however, is that most people fail miserably when it comes to investing in the stocks of single companies.

In order to fit nicely into a graphic, I’ve parsed down the thought process to make it simplistic. Life is not black and white and decisions like these are almost exclusively always in the ambivalent gray areas. This lack of certainty can lead to analysis paralysis.

 

 

Do you have debt?

If you have debt, you have no business investing in individual stocks. If your company lets you purchase stocks through an Employee Stock Purchase Program (ESPP) with a substantial discount…I don’t care, pay off your damn debt. If your debt has a very low interest rate (mortgage, for example) then you could be an exception to this. Your debt is generating a guaranteed loss. There is no such thing as guaranteed return.

Do you have other sources of liquidity?

Liquidity basically means cash you can readily access. As often happened to me when I was young and stupid, I’d make a great investment and then be forced to sell at the worst time because I didn’t have an adequate emergency fund for things like my car’s engine catching on fire (actually happened) or 5 friends all getting married within a few weeks of each other in different cities. If you can’t weather a large surprise expense, you’ll be forced to sell your stocks instead of selling them exactly when you want to. This rule doesn’t have any exceptions.

Are you maxing out your tax-advantaged accounts?

The government, in the hedge fund world, is known as “everyone’s silent partner”. They offer no input but take a substantial amount of your profits. If you can goose your gains by deferring the taxes on them or avoiding taxes altogether (legally, of course), you’d be silly not to. Get that annual gross income number down and keep more of your money. If alpha is gain above a benchmark, taxes and fees are zeta…alpha killers. Minimize zeta, max alpha.

Can you handle losing the entire portfolio value?

Not just literally (as a Millenial, I love using this word), but emotionally? If you don’t have the temperament to watch your portfolio decline in value by 20% or more without freaking out and selling, you don’t need to be investing in single stocks. This emotional panicked selling or FOMO (fear of missing out) driven buying is the reason most people can’t beat the S&P 500. Don’t be a sucker. Additionally, don’t put your entire life savings into a portfolio of single name stocks. Don’t invest your rent money in a hot stock tip.

Are you comfortable with a concentrated portfolio?

I personally think that a portfolio composed of single-company stocks should not number more than 10 positions. Why? You need to put in a LOT of time researching each individual company before investing in it. If you don’t fully comprehend what the company does, or things like what distinguish it from competitors, you will find it much harder to sit tight if/when your company starts taking a beating. You want to sell because there’s good business reason to. A full time hedge fund analyst has a difficult time knowing the ins and outs of 20 companies. More than likely, your full time job isn’t managing your portfolio. So 10 is the max number of companies I feel comfortable investing in because between the demands of my job and family, I don’t have time to keep up with more companies than that. Many times, I simply can’t find that many good deals in the market so I pass and have fewer than 10.

“What about diversification?”

Diversification is for people who have already retired. If you’re young, contribute to your 401k (those mutual funds should already be diverse), and have a long runway ahead of you, you shouldn’t be looking to diversify. You need to generate portfolio growth and make your nut. Wealthy people rarely become wealthy through diversification. They excel at one thing or one area. Once you’ve made enough money to retire, then diversify.

No reputable business school teaches a full course on technical analysis.

 

Can you read financial statements & value companies?

If you don’t know basic accounting and know at least the basics of valuing companies, DO NOT invest in individual stocks. I don’t care what Cramer says or if the stock chart is showing a “cock and balls pattern” or what the Bollinger bands are saying. No reputable business school teaches technical analysis. It’s like reading tea leaves. Remember the SATs? Try this….astrology : astronomy, alchemy : chemistry, medicinal: medicine, metaphysics: physics, technical analysis : investing.

LBO, discounted cash flow, sum-of-the-parts analysis, liquidation analysis, comparables…if this is gibberish to you, do not invest in individual stocks. These methods all have flaws (mostly based around projected assumptions) but being able to execute these methods implies a certain level of competence with the financial statements of a company.

Conclusion

Am I trying to be a buzzkill? No, of course not. I’m trying to keep you from making the same mistakes I made and losing money.

So what, that’s it, you can never invest in individual companies?

No. Be proactive. Take an accounting course online (there are plenty of free ones), read books on value investing (can’t go wrong with Ben Graham), and invest in your own knowledge. Once you’re in a financially desirable place and know what you’re doing, invest in stocks. The more you know about investing, the more you realize there is so much to know that you’re lucky to get it right more than half the time.

 

Keep checking this blog. In the next few weeks, I’ll be putting together a comprehensive list of the resources you need to get the same knowledge >this dude< paid over $100k to get at business school (and that’s with a full tuition fellowship!). 

 

*Fun Fact: I slept on the floor for six months because I invested all my “mattress money” in Google’s IPO.

 

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6 thoughts on “Should You Invest in Individual Stocks? Probably Not.

  1. I’m going to have to disagree with the statement there is no such thing as a risk free return. ESPP and 401k match are these. Unless your company blinks out of existence before you receive them, they are part of your compensation. That being said I’d only consider an ESPP if it allows you to sell at the same time it buys and if the discount exceeds the volatility you would expect over the period from posting to your brokerage and availability to sell. For the 401k match, I’d take it unless your looking at missing a debt payment. I also disagree that diversification is for the retiree, you should just use index funds to diversify (which you do reference). Diversification is about ensuring not all your cash is in one basket in case one of those positions goes bust over night. Enron for example. It’s not for index funds. I do ultimately agree though, if your questions are not yes then individual stocks should be avoided. In fact even if they are all yes you might want to avoid individual stocks.

    1. We’re on the same page for the most part. Strictly speaking, even a company match isn’t technically risk free because that could also theoretically go to zero. What is typically used as the Rf rate, the 10 year US government treasury bond, is also not risk free. There is always some risk. However, I fully advocate using the 401k, ESPP, and any other advantages before investing in single names. Also agreed, you may not want to invest that way after all this and it’s understandable given the time commitment. I stand by my point, however, that IF you do go down this path after exhausting all other investments, you need to be going after growth and the volatility that it typically encompasses. Your retirement accounts are diversified already.

  2. Stocks are definitely on the expensive side. Looking at valuation indicators like P/E and Tobin’s Q, the stock market is definitely above average (long term valuations).
    However, that doesn’t mean stocks can’t go up much more! Stocks were overvalued by 1995, and then still soared for 5 more years!

    1. Generally, I use the CAPE ratio as an indication of how expensive the overall market is. Sure, we could have another 5 years of bull markets, but things don’t generally continue to go well when the ratio is this high (~29 now). While I always maintain some exposure to the market because it’s impossible to time it, my exposure has an inverse relationship to the CAPE ratio. More on that in a future post.

      http://www.multpl.com/shiller-pe/

      Thanks for commenting Troy, and you have an interesting website. Will definitely be digging through it in the next few days.

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