Should I invest in individual stocks, or is there another way to win in the stock market?
The Dow Jones, a stock market index that measures the stock performance of 30 large companies listed on the US stock exchange dropped by 30% to 20,188 in March 2020.
In the following months, the market fluctuated, with the Dow Jones eventually reaching a record high of 31,041 in January 2021, up over 50% from its March 2020 low.
Over the past year, people traded individual stocks hoping to take advantage of market fluctuations. Some people made money trading heavily, while others lost money.
A few panicked and sold investments in their portfolio during the stock market dip or stayed on the sideline. Others continued to invest regularly.
Introduction to the stock market
The market’s volatility this past year reminded me of when I first started investing in my early twenties.
I spent hours a day researching stocks, trading, and following the stock market’s movement. Thinking back, following the market highs and lows made me emotional, and emotion is the enemy of investing.
Shortly after, I stopped day trading and adopted a long-term strategy.
With time, I went a step further and, for the most part, started avoiding individual stocks.
When the stock market dropped significantly last year, I felt much calmer because I had changed my investment strategy.
I barely invest in individual stocks these days. I also stay away from mutual funds^ (unless required to participate in an employer’s retirement account) and have turned to exchange-traded funds* (ETFs) or index funds^^, and here’s why.
Buying individual stocks, which is purchasing shares in a single company, is riskier.
A company could be doing well now, but we’ve seen what happened with Enron and how people lost their money when their fraudulent accounting practice came to light, and their stock priced dropped from $90 to under $5 and tanked the market in the process.
Related article: Pulling the plug on Enron
How to mitigate risk?
To mitigate risk, diversifying your portfolio by buying stocks across different companies and industries is key.
A good rule of thumb is that an individual stock should not represent more than 5 percent of your portfolio.
If the price of a stock that you own were to drop due to industry challenges, such as the airline industry in 2020, when travel significantly decreased due to the pandemic, your portfolio would be at greater risk the more shares of airline stocks you owned.
When you diversify your stock holdings across different industries, it helps mitigate the risk. However, you would need to own at least 30 individual stocks, and purchase across different industries to have a diversified portfolio.
An easier alternative is to invest in mutual funds, index funds or ETFs, for a simpler way to diversity your portfolio.
Why funds are an easier alternative to consider.
Mutual funds industry-specific index funds or ETFs allow investors to hold a hundred or more stocks into a single fund.
ETFs or index funds following the S&P 500, like Vanguard’s VOO or iShares’ IVV funds, own shares in 500 different companies.
If the share price drops for one of the companies, the fund will not be affected as much. Funds like Vanguard’s VTI or iShares’ ITOT own shares in each company listed on the US stock market.
Purchasing a total market fund is putting your confidence in the market and its ability to recover after a downturn as it always does rather than picking specific winners.
Also, adding an international component like Fidelity’s FSPSX or Vanguard’s VGTSX makes your portfolio more diversified and further reduces risk.
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Trading stocks often involves a transaction fee. However, many companies now offer commission-free transactions, which allows you to trade without paying fees.
Though you might be able to avoid the transaction fee, there are other costs involved.
When trading outside of a tax-advantaged account, you will have to pay taxes on the profit that year. If you hold the stock for less than a year, you will be taxed at your ordinary-income tax rate.
You won’t be able to take advantage of the capital gains rate, which is usually lower.
Choosing to trade mutual funds is likely to reduce the number of transactions; but mutual funds are actively managed.
For that reason, they tend to have pretty high expense ratios. The expense ratio for actively managed funds, the annual fee to hold the investment, is typically around 1- 1.5% compared to 0.03% for an ETF like VTI.
Why you should be concerned about 1-1.5% expense ratios.
The fee seems low, but it is significant over time because the fee is taken from your portfolio every year. It reduces your invested amount every year.
The article attached illustrates the big difference fund management fees can make over time.
Related post: How Investment fees cost you your freedom
Lower expense ratios are why I opt for exchange-traded funds and index funds in favor of mutual funds. The average ETF and index fund carry an expense ratio below 0.5%.
Over time, that difference results in significant savings, especially since it leaves you with more money to reinvest at the end of the year.
Will fund managers provide better returns?
It can be reassuring to pick mutual funds because fund managers manage them, but history has shown that less than 5% of fund managers are able to beat the market.
Also, a fund manager’s ability to beat the market in the past doesn’t guarantee their ability to do it again. The extra cost associated with an actively managed fund is usually not worth it.
No emotions involved
Investing in ETFs or index funds on a dollar-cost average basis is emotionless. Every week or month, you can determine an amount to invest without looking at share prices.
The market movement has no impact on you because you continue to invest whether the market is up or down.
You are in it for the long run. Over time, you can safely expect an average annual return on investment of 6-7% after accounting for inflation.
Picking individual stocks is time-consuming. It takes time to research the company and industry and look at its reports and press releases.
If you spend hours a week analyzing stocks, you can make more than the expected 6-7% yearly return after inflation. But you might also lose more if things don’t go the way you expect. Over time, that’s the case for most investors.
Tesla is one of the most talked-about stocks of the past year. Is it a good investment now at close to $850?
Will you have the opportunity in the future to buy it at a better price? Time will tell. But there’s another way to own a piece of Tesla. If you own shares of a total stock market fund, you owned a piece of Tesla before it was added to the S&P 500.
Also, an ETF like ARKK focuses on investing in tech companies like Tesla. Those options allow you to participate with less risk and emotions.
Individual stock investing involves speculating on the winners. Investing in index funds, is more like betting on the overall market and benefiting from the winners in the process.
Should I invest in individual stocks as opposed to low-cost funds, or should I do both? Those are personal decisions.
It’s essential to take your risk tolerance level into account before deciding. Also, think about how much time you can dedicate to stock trading.
Ensuring you have a diversified portfolio of 30 stocks or more is necessary to lower risk.
While some people enjoy researching stocks, I would rather spend time doing other things that I value.
For that reason, I focus on index funds and keep my individual stock ownership to a minimum.
I favor a portfolio with less than 10 percent in individual stocks, no more than three individual stocks with a long-term holding strategy.
An interesting analogy I saw recently compared buying individual stocks to buying total stock market funds to owning a single NBA team vs. having a stake in the entire NBA league.
Imagine if you had the choice, would you rather own a piece of a team that might significantly increase or decrease in value, or would you rather own a stake in every team in the NBA?
“If you like to spend six to eight hours per week working on investments, do it. Otherwise, dollar-cost average into index funds.” Warren Buffet
To learn more about investing and a simple path to financial freedom, head to this link to get a copy of my book, Dream of Legacy.
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Mutual fund ^: A mutual fund is an investment strategy that allows you to pool your money, together with other investors to purchase a collection of stocks, bonds, or other securities that might be difficult to recreate on your own.
A fund manager actively manages mutual funds.
Exchange-traded fund *: An exchange-traded fund (ETF) is a basket of securities that trade on an exchange, just like a stock.
ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds that only trade once a day after the market closes
Index fund^^: An index fund creates a portfolio of stocks that mirror the collection of companies and the performance of a market index, such as the S&P 500.
Index funds are passively managed and have lower fees than actively managed funds, often generating higher investment returns.
The article above does not constitute financial advice. It is for entertainment purposes only.