Why individual stocks are poison

I’m on tour to promote my new book, MAKING THE MOST OF YOUR MONEY NOW, and I’m getting the same question everywhere: What do I think about this or that individual stock? I always say, “Beats me.” What’s more, I don’t even care. Friends don’t let friends buy individual stocks.

I’m optimistic about the stock market for 2010, even though there might be a bump or two along the way. But the way to play it, for investors like you and me, is by buying well-diversified stock-owning mutual funds. Trying to pick good companies is a million times harder, and riskier, than you think. Who would have expected a worldwide financial corporation like Citibank to fall apart?

There’s a screed in my book called “The Case Against Buying Individual Stocks,” and here it is:

As a long-term investor, you might think that your job is to find “great companies” and hold their stocks forever. But “great companies” don’t necessarily last. The superstars of 1990 were has-beens by 2000. The leaders in 2000 soon saw their stocks collapse. In hindsight, you can always find stocks with wonderful long-term records. But you can’t know in advance which ones they’re going to be. You take big risks when buying individual stocks. Here’s a short list:

1. You overpay. A stock price is supposed to reflect the company’s expected growth in future earnings and dividends. But when stocks are popular, people bid up their prices to unrealistic levels. In the late 1990s, tech stocks were selling for far more than they could ever deliver in earnings growth. Investors kept buying them anyway, based on the theory of “greater fool” (as in, “I may be a fool to pay this high price but I’ll sell it to a greater fool who will pay even more”). Prices collapsed when the last fool decided not to play. Microsoft was and is a great company, but in 1999, it definitely wasn’t a great stock. After the 2008 collapse, it turned out that the famous financial stocks weren’t even great companies.

2. You buy stocks that are in the news. That’s where you hear about companies—and, of course, so does everyone else. Newsy stocks are more apt to be overpriced, compared with companies you’ve never heard of. You hear about underpriced stocks only after they’ve risen 50 percent (and they’re newly in the news!). Stockbrokers like to sell newsy stocks because those are ones you’re mostly likely to be interested in.

3. You buy and hold. That’s what long-term investors are supposed to do. But business moves too fast today. Only a very few companies turn in splendid long-term results—mostly those in traditional businesses and paying dividends.* Others bite the dust. To keep a portfolio of good stocks you have to weed them constantly—selling some and buying others. Not even the smarties who run the managed mutual funds can pick all the right stocks over time. And neither can you or I.

4. You don’t know—and cannot know—what’s going on in a company. If you own an individual stock, take this little test: How good is the business? What are the trends in profit margins, sales rates, and inventories? How competent are its top executives, what are their problems, and how are they handling them? Is the market share rising or falling in the company’s various lines of business? What’s the competition up to, at home and abroad? You probably can’t answer these questions and there’s no reason you should. Without answers, however, you have no basis for deciding whether to buy, hold, or sell the stock. After the once-lordly Lucent tumbled, we discovered that it had made a wrong bet on fiber-optics technology and its management was a mess. Who knew, until we read it in the newspapers and the stock was down 90 percent? And who every heard of credit default swaps before 2008?

5. You don’t diversify. To be properly diversified, you’d have to hold 50 or more stocks in various Industries and in companies of different sizes. Individuals can’t do that. You hold just a few stocks, in popular companies. If one of those companies goes bad, it’s hard to recover.

6. You have no idea how well your total stock portfolio has performed. Typically, you remember your winners, every single one of them. You forget your losers. You never average the two together. So you have no idea whether you’ve done as well as the market, over time. Almost certainly, you’re behind.

7. You are up against professionals who watch (or whose computer programs watch) the market 24/7. They’re on the other end of your trades. Do you really think that you know more about a stock than they do?

Stocks have an entertainment value, for people who like the game and have time on their hands. It’s exciting to see a stock go up (I won’t mention the down). If you love to play, set aside 5 percent of your investment fund and cheerio. But do yourself and your family a favor and keep your long-term, life changing money in well-diversified mutual funds.

Thus endeth the lesson.

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22 comments
LAUREN // 01/13/2010 at 5:12 am

Hi Jane,
Is the Tocqueville Gold Fund a mutual fund?
How about GDX and GDXJ?
What is the difference between a mutual fund and an ETF?
I ‘m confused about whether they classify as mutual funds as you write your advice. thanks. Lauren

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Jane // 01/16/2010 at 10:34 am

Lauren–I’ll write about this soon

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harry // 01/13/2010 at 5:22 am

Now you are happy you bought those gold coins in 1980, yes?

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Neil Morrison // 01/13/2010 at 12:15 pm

Love this, Jane. It makes so much sense, intuitively, and wisely goes against the grain of so much of the kinds of hype we hear on radio, TV, even newspapers.

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Jane // 01/16/2010 at 10:33 am

Harry–Actually, not happy. I’m patient, but waiting 29 years to break even is too much even for me!

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Perkins // 02/04/2010 at 12:02 pm

Hi Jane…I’ve read only some of it, but I love your new book! I do wonder about utility stocks, though. I looked for information about utility stocks in your book…no information. Aren’t utility stocks supposed to be safe? Hawaiian Electric’s stock is at 8.03%

I’d love to know what you think about utility stocks…can they be commission-free?

Can they be bought WITHOUT a stockbroker?

I can’t wait to hear your words of wisdom on this.

Many thanks,
Perkins

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Jane // 02/04/2010 at 12:27 pm

Are utility stocks safe? Enron was a utility stock. Old-fashioned, publicly regulated utilities were less volatile than other stocks and paid regular dividends. Ever since deregulation, utilities are less reliable. If you’re reading my book, you know that I’m not in favor of trying to pick individual stocks. Yes, there are utility mutual funds. Vanguard has an ETF, which you can buy by opening a Vanguard account (no broker). Fidelity has a traditional utility mutual fund.

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Perkins // 02/04/2010 at 12:10 pm

One more thing…is there such a thing as a mutual fund that does only utility stocks?

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William Cuthbertson, MBA, EA, CFP(r) // 02/06/2010 at 1:20 am

Great advice! The key to a successful investment experience is a long term outlook (short term money should NOT be in the stock market), and a low-cost, globally diversified, low-turnover, portfolio. Anytime you buy individual stocks, or attempt to time the market you’ve moved from investing to gambling. This is what Wall Street doesn’t want you to know – those that do better than the markets (and yes, this includes professionals), most often do it out of luck, not skill.

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Perkins // 02/08/2010 at 10:40 am

Good morning!

This is such a fun discussion! I know some people who do not like mutual funds because of their fees and tax consequences. Hence, they invest only in individual stocks. What can one do about the tax consequences of mutual funds?

Thanks,
Perkins

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Jane // 02/09/2010 at 9:48 am

I don’t buy mutual funds that have high fees. You’ll see in my book that I prefer index funds, and I explain why. Index funds are VERY low in cost. Index funds own some stocks that pay dividends, which are passed along to you. The result would be the same if you owned dividend stocks directly.

The major tax complaint about mutual funds is that, in a good year, a lot of capital gains taxes are passed along that you have to pay, even though you didn’t sell your shares. That is true of funds that trade a lot. Those funds also run up brokerage expenses. An S&P index fund rarely trades, so there are typically no taxable gains to pass on.

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Perkins // 02/11/2010 at 7:02 am

Isn’t the QQQ an index fund? What do you think of it?

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Jane // 02/12/2010 at 8:35 am

The QQQ (now the QQQQ) is an ETF (a fund that trades like a stock) representing 100 principally high-tech companies that trade on the Nasdaq exchange. It’s an index for a particular, and speculative, portion of the stock market, not representative of the market as a whole.

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Perkins // 02/11/2010 at 9:49 am

Charles Givens had some really interesting things to say…I don’t agree with everything he says, but he does have some really fascinating ideas, such as…look at the Prime Rate to see what you should be invested in. For example, he said the following:

****
Can you ever make money in a money market mutual fund? Of course. In 1981, with the Prime Rate averaging 18%, money market funds were paying as much as 20% interest! Of course, when the Prime rate is 11%, and you are in a money market mutual fund, you are averaging only about 11% on your money.
******

How can I find out what the current Prime Rate is? He said that it’s the easiest of the interest rates to follow. It moves slowly and does not change direction as often as stock prices do. It has changed direction only 11 times in ten years (at the time the book was written).

Will the Prime Rate ever be at 20% again?

With smiles,
Perkins

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Jane // 02/12/2010 at 8:30 am

As you may remember, Charles Givens had a lot of legal troubles and, before his death, got out of the financial advice business. You can find the prime rate by entering the term into any search engine or at bankrate.com. Money funds will be 20% if hyper-inflation hits the US–in which case your 20% interest still won’t be worth anything, in extra purchasing power

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Perkins // 02/14/2010 at 12:55 pm

I see from bankrate.com that 3.25% has been the prime rate for the past year or so. Is it true that money market mutual funds are always higher than the prime rate? That is, if the prime rate is 3.25%, does that mean that the interest rate on a money fund will definitely be at least 4%…or at least more than 3.25%?

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Jane // 02/20/2010 at 6:26 pm

The prime rate is a lending rate. Money funds are tied to savings rates, which are lower. A money fund largely in Treasuries returns less than 1% today.

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Perkins // 02/14/2010 at 1:19 pm

I’ve been wondering for 2 years where to put my IRA..since I know very little about investing, I’ve been reading up on it for many months, but I still have a long way to go. Right now, my traditional IRA is in a savings account…which is a temporary parking place. I was wondering if I could put it in a high-dividend REIT? I currently have $14,000. Should I put only 5% of it in a REIT and the rest in a nice index fund? Or all of it into a lifecycle fund? I’m 48 years old.

I have doubts about lifecycle funds..so I was thinking of putting the IRA into 7 or 8 different things…maybe a little bit into a REIT? a little bit into an index fund..a little bit into a bond fund..a little bit into a money market mutual fund? But I have no idea how to rebalance..in fact, i didn’t even know about rebalancing until last year…I will be adding another $5,000 for this year…from savings.

Or maybe I could just put it all into a safe enough REIT that has both high dividends and just enough growth to make it worthwhile. I tried interviewing 2 financial advisors in order to get some help with my IRA, but I was not comfortable with them..so I did not hire them. I would rather read your whole book before hiring any financial advisors so I can protect myself from the unscrupulous ones.

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Jane // 02/20/2010 at 6:24 pm

Put it into a target retirement fund–e.g. Vanguard, whose target funds follow index funds. It will be rebalanced for you automatically, which is a way of limiting risk. If you put it all into REITs, you are betting on just a single, narrow part of the market to perform well. All your eggs in one basket. And thanks for reading the book–you’ll help with advisers in Chapt 32.

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Perkins // 03/23/2010 at 9:48 am

Some time ago, I posted a question about TIPS…now I can’t find it so I can’t find the answer. I can’t remember where I posted it.

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Perkins // 03/23/2010 at 1:56 pm

Hi,

It doesn’t work when I try to post a question or submit a comment?

What happened?

Perkins

Reply
Jane // 03/23/2010 at 9:50 pm

Hi, you’re posting correctly. Comments come to me first for approval first, then I put them up.

Reply
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