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.