Ask a beginner-level investor what investing is about, and you’re likely to get an answer to the effect of, “Buying stocks of companies that are likely to grow quickly.”
That’s understandable, since it’s the lesson one might gather from much of the mainstream financial media. But that description is way off base for two reasons:
- It’s important to own investments other than stocks (most importantly: bonds), and
- There are very few circumstances in which it makes sense for an individual investor to own individual stocks rather than mutual funds.
The reason it’s (usually) such a bad idea to own individual stocks is that it results in more risk without (in most cases) the expectation of higher returns.
Why Are Individual Stocks Riskier?
This is the easy question. The more of your portfolio you have invested in any one company, the more risk you’re exposed to. Nothing hard to understand about that.
By investing in a broadly-diversified mutual fund (for instance, Vanguard’s Total Stock Market Index Fund, which includes over 3,000 different companies), your portfolio will be exposed to far less company-specific risk than if you own just a handful of individual stocks.
Why Is it Hard to Pick Above-Average Stocks?
This is the question many investors struggle with. Many people are unaware of the fact that there’s more to picking winning stocks than simply finding companies that will experience above-average growth.
At any given moment, a company’s stock price already includes the market’s best estimate of the company’s future growth. So a stock’s performance isn’t a function of how quickly the company grows. It’s a function of how the company’s growth compares to its expected level of growth.
In other words, picking an above-average stock does not mean finding a company that’s going to grow quickly. It means finding a company that will grow more quickly than the market expects it to.
And that’s no small task. The market is made up of millions of individual investors as well as a small army of highly-intelligent, specifically-trained professionals whose sole job is to estimate such growth figures. It’s silly for most individual investors to think that we can reliably outsmart such a massive collection of data and intelligence.
When Might It Make Sense to Own Individual Stocks?
Despite all of the above, there are a few scenarios in which an investor would want to own individual stocks. For example:
- Your company’s retirement plan gives you shares of company stock, and you’re not yet allowed to sell it (or you’re holding it to take advantage of the Net Unrealized Appreciation rules), or
- You’re looking to do something other than maximize your returns for a given level of risk. For example, you derive an entertainment benefit from picking stocks or a self-actualization benefit from buying the stocks of companies that do things you morally approve of.
But for most investors, there’s no reason to own any individual stocks whatsoever. Doing so just increases the risk in your portfolio without increasing your expected return.