No doubt there will be a few folks that read the above headline and immediately conclude that I have to be crazy. Bear with me as I make a case on why buying INDIVIDUAL stocks is normally not a good idea…

Let's talk about risk.

On Friday, September 18, 2015 the news broke that Volkswagen had intentionally modified the computers in over 500,000 vehicles to reflect lower levels of harmful emissions. The stock market responded swiftly with Volkswagen stock down almost 25% in a single day.

For those with a short memory, try googling Enron, WorldCom, Tyco, or Bearn Sterns. Each and every one of these companies was a darling of the stock market at some point in time. However, each and every one of them fell from their lofty position. This IN SPITE of the financial gurus singing the praises of these companies.

The companies suffered these falls due to the inappropriate behaviors of individuals inside the company. And even though the financial gurus were continually monitoring and interacting with the companies, they (the gurus) missed these inappropriate behaviors. A couple of question for you:

• Do you really know anything about the management of the individual stocks that you own?
• Will Volkswagen follow the same path as the above companies?

For both of the above questions, I do not know the answer. And most people do not know the answers either. And that is the primary reason that, in my opinion, individual stock ownership should be avoided.
Every company is exposed to business risk. By business risk I am referring to the uncertainty of the environment that the company operates within. In today’s world, business risks can arise out of thin air much more quickly than in the past. While the examples that I cited above were driven by the shortcomings of individuals within the companies, there are countless examples of companies that suffered the same fate due to external influences. Remember to tech boom back in 2000? How about 2008? Both of these periods introduced massive, unanticipated business risk. In both of these periods the overall stock market suffered vis-à-vis the bankruptcy of numerous individual businesses.

Buying an individual stock means that you are assuming the business risk associated with that company.

In my opinion, most people are not sufficiently informed of the operating principles of that company and also do not fully understand the risk they are assuming. If is for this reason that I am not a proponent of purchasing individual equities.

In my opinion, the vast majority of investors are better off purchasing COLLECTIONS of companies via mutual funds. If you like the tech space, my preference would be to buy a tech mutual fund versus 2-3 tech companies. Like small caps? Buy a small cap fund versus 10 to 12 small cap companies.

Will you always do better by going the mutual fund route?

ABSOLUTELY NOT! However, consider this.

• There are countless, highly educated, well-funded, totally focused, investment professionals spending well over 40 hours a week evaluating the prospects of those same individual stocks that you are about to buy. Do you really think that you are smarter than all of them?

Yeah, I know the counter argument: I’m not smarter than them, I’m using them/following what they are doing. Guess what? For every one of the guys that you are following that bought yesterday, somewhere there’s another equally well educated guy that sold. And they both think they got a screaming deal. That is how markets work. Every buyer thinks he is smarter than every seller. And every seller thinks that he is smarter than every buyer.

Risks of individual equity ownership.

There is another exercise that you can do that illustrates the risks of individual equity ownership very well in a number of cases. Assume you are considering purchasing a large cap stock. Head over to Yahoo and pull up the 25 year performance of the stock. Now over lay it with the 25 year performance of an S&P 500 index mutual fund. What you will often see is two things. First the lines cross at several points. Second, the line associated with the individual stock has higher highs and lower lows. If you observe the above, there are two conclusions you can draw:

• If you look at the time period between where the two curves cross, the stock and the mutual fund had identical performance.
• As the stock curve has higher highs and lower lows, it had more risk (as measured by standard deviation) than the mutual fund
  If you observe the above two things, the conclusion that I draw is that purchasing the individual security introduces higher risk with no higher return.

Now I will admit that IF you were to buy the stock at the lowest point and IF you were to sell the stock at its highest point, you would certainly do better. But IF you knew how to buy low and sell high consistently, you would probably already be so wealthy that you would not be reading about the reason to avoid buying individual equities.

Finally I’m not a big fan of purchasing individual stocks for one other reason. Time. I’ve met many people that think I’m wrong about individual stocks. Many of these people inform me of the errors of my way. They share with me the effort and processes they put in place to make decisions on individual equities. And these efforts and processes take countless hours away from their life. Further, many of these people cannot show any results of their effort (vis-à-vis superior performance); and, those that do show superior results very often admit that they only follow the individual equity “game” with a small portion of their investment dollars. Time is money. And many people that invest in individual securities do not recognize or appreciate this fact.

Is there ever a time to buy individual equities?

Absolutely. A couple of that come to mind include the ability to purchase stock at a discount via your employer and the need to own stock in a company to show commitment (i.e. board member, equity compensation, etc.).

So what’s the point of all of this?

Simple. As a general rule, buying individual stocks introduces additional risk (variance) in your portfolio versus implementing a portfolio strategy based around mutual funds. As most of us are NOT financial gurus, we are unlikely to be compensated for this additional risk.

Standard disclaimer: Every person’s situation is unique and only they can evaluate what is in their best interest. The above is offered as some thoughts on the topic of investing in individual equities. Ultimately only you can make the right decision for you.

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