ARTICLE: Individual Stocks - "A Losing Game"

The popular investment phrase, "a rising tide lifts all boats" was never more evident than during the bull market of the late 1990's. It seemed that no matter what stocks you invested in, you couldn't help but make money. After all, who could forget the commercial in which a suburban mom who returning home from jogging, punches a few keys on her computer, sells a little biotech stock, and announces, "I think I just made about $1,700." Or how about the ad for an online trading Brokerage firm in which a tow-truck driver and his passenger have the following conversation;

Passenger: You invest online?
Tow-truck driver: Oh yeah, big time. Well, last few years anyway. I'm retired now.
Passenger: You're retired?
Driver: I don't need to do this -- I just like helping people.
Passenger: (Noticing a picture of an island) Vacation spot?
Driver: Actually, it's a picture of my house.
Passenger: It's an island.
Driver: Well, technically it's a country. Weird thing about owning your own country, though, you have to name it.

Obviously the gains achieved by the characters in these ads were fictional. Unfortunately, for the thousands of investors who lost a small fortune during the stock trading frenzy during the late 1990s, their losses were not. When it comes to investing in the real world, I am convinced that most individuals should not be investing in individual stocks. I realize that as a financial advisor that may come across as a bit condescending, however I would like to add a little disclaimer. I do not now, nor have I ever invested (risked) one cent of my retirement, or my child's college savings in individual stocks. My savings as well as my client's assets are invested in mutual funds.

It never ceases to amaze me that most investors think that by paying a couple of hundred dollars for a newsletter, logging onto Yahoo!, or relying on the stock predictions of their favorite financial publications they actually think they can consistently pick stocks that will outperform the market. Unfortunately, this type information provides you with no more ability to pick individual stocks than to pick numbers on a roulette wheel. Imagine you just finished reading an article in The Wall Street Journal about the XYZ Companies new product line that could revolutionize its' industry. Its stock price is currently selling at $50, and after reading the article you are quite confident that its share price will go to $75 or possibly even $100, so you decide to buy it. Now think where you just read about this new insightful information, in one of the most popular financial newspapers in the country. The truth is if you read about XYZ in The Wall Street Journal, the chances are pretty good that thousands of other investors read the same article as well. And what about the hundred or so stock analyst's covering XYZ for billion dollar pension firms and mutual fund companies? Do you really think they would let a stock that is obviously worth $75 or $100, sit there at $50 without rushing out to buy it? The reason XYZ is trading at $50 is that the information in The Wall Street Journal, in addition to any other publicly available information about XYZ have already been factored into the price of the stock. As a result, the market as a whole thinks that it is worth $50 and not $75 or $100.

With so much investing information available today via the internet, financial publications, investment newsletters and cable television, finding information about a company is easy. Finding "useful information" however that has not already been factored into the price of its stock however, is another. Confusing the two is perhaps the most common misperception individuals have about investing in individual stocks. There are basically two ways individual stock investors can consistently outperform the market. The first is by having privileged insider information about a company. To trade on such information however, is a violation of the securities laws of the United States, (just ask Martha Stewart). The second way is to interpret the information differently (and more correctly) from the way in which the market collectively does. In other words, to outperform the market, you must consistently discover and exploit investment opportunities that have been missed by other investors due to their errors, incompetence and/or inattention.

Right now, if I wanted to, I could screen a database of more than 7,000 publicly traded U.S. companies according to hundreds of different characteristics. There are also dozens of inexpensive, commercially available software programs capable of this, and they reside on the hard drives of hundreds of thousands of small and institutional investors seeking to find the top performing stocks. On top of that, there are tens of thousands of professional investors using the kind of software, hardware, data, and underlying research that you and I can only dream of.

Over the last few years, thousands of investors unfortunately learned the hard way about the risk of investing in individual stocks. Many investors were outraged when Enron, the seventh largest company in the U.S., lost tens of billions of dollars, and went into bankruptcy in 2001. I can certainly sympathize with individuals who sustained these significant losses, but part of the risk of investing in individual stocks has always been that you might end up holding an Enron. Every year some companies, no matter how much you think you may know about them, are going to fail whether it's due to, greed, incompetence, a corrupt CEO, or bad luck. But the cause of the failure is irrelevant to you as the investor; your money is still just as lost. What should matter to you is developing an alternative approach to investing that can help protect your savings from this kind of risk. There is an alternative; mutual funds.

By owning shares in a mutual fund instead of owning individual stocks your risk is spread out. The majority of mutual funds typically own hundreds of different stocks in many different industries. As we have seen in the recent past (Enron, WorldCom, and Global Crossing, just to name a few), corporate bankruptcies can occur very rapidly and wipe away investor's hard-earned money. However, holding a properly diversified portfolio of mutual funds can help insulate investors from the adverse market events that can negatively affect a company, country, region, or asset class.

It is said that there are only two kinds of investors: those who don't know where the market is going, and those who don't know that they don't know where the market is going. In other words, if you are smarter, have better insight, access to more useful investing information than the rest of the market, and are capable of earning $1,700 a day or buying your own island, you should probably continue investing in individual stocks. However, for those of you who are less confident in your ability to predict the future, or your investment goal is something less exciting like saving for retirement or your child's college education, you may want to consider investing in a properly diversified portfolio of mutual funds.

 

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