Quite naturally, you are putting in money in an investment in the hopes for high returns (which can be compelling with individual stocks. However, individual stocks also expose an investor to high levels of company-specific risk. All risks taken should be compensated with higher returns, otherwise, they are neither optimal nor rational. The Modern Portfolio Theory (which is generally well respected in the field of Finance) hypothesizes that a portfolio with a minimal number of different company’s stocks exposes the investor to high amounts of company-specific risk of which they are not compensated for with higher returns. A better approach is investing in diversified securities like Mutual Fund or ETFs (more on this later).
Individual stock investments can work for some people, and this article is going to tackle both the pros and cons of individual stock investments. But first, we need to talk about the differences between investing in individual stocks and investing in diversified securities like ETFs.
What’s the Difference?
Individual stock investments are simply buying a share, or multiple shares, of a single company’s stock (for example buying 5 shares of Apple stock). These investments are tied to the company’s growth, earnings, and perceived value.
Mutual Funds or index funds involve investing in a pool of multiple companies at the same time. You can pool your investment with other investors and buy hundreds or thousands of stocks in a wide range of companies and sectors. This investment style is different in the sense that individual stock investments focus on a single company and a single stock. Mutual Funds or index funds like ETFs offer a very cheap way for the average person to achieve a well-diversified portfolio.
Why Should You Not Invest in Individual Stocks?
There are multiple reasons why I discourage investing in individual stocks. One of the primary reasons is that the stock market is volatile. Prices can rise and fall very quickly. If a company that you’ve invested in has bad news or a bad earnings report, the price will likely fall substantially before you can react.
The market moves very quickly, and most large financial institutions already have systems installed that make buy-sell transactions almost instantaneously. The average person has a minimal chance of beating them to the sale, and the company’s share price will fall almost instantaneously.
On the contrary, if you are instead invested in an index fund that contains 500 different stocks, bad news from a single stock will hardly affect your portfolio because your exposure to any individual stock is negligible.
There Is Significant Uncertainty for Any Individual Company
The average person generally does not know what the future holds and what internal or external factors will cause a company’s stock price to fluctuate substantially. Our hunches can often feel infallible with regards to a company’s future success. But consider that 90% of traders have historically failed at outperforming the benchmark index, and they at one point considered their hunches to be infallible as well.
Diversifying your investment minimizes the risks you face in the sense that other stocks can now cover up for a bad investment, and this helps in significantly minimizing your losses. With a diversified stock investment portfolio, you will generally see your investments rise and fall with the overall stock market.
Individual investors with diversified portfolios will be minimally affected by major losses of any single company. However, diversifying your stock portfolio by buying huge volumes of individual stocks of different companies is too costly for the average person. Therefore, many investors turn towards index funds (like ETFs) which allows them to pool their money together and purchase a huge basket of different stocks at a low price.
Trading Individual Stocks Takes Time to Learn
Most people cannot become successful stock traders without significant hands-on experience as this domain takes time to learn. Often, successful traders of individual company stocks have learned from past mistakes and initially sustained large losses before improving to get to where they are today. If you want to partake in individual stock investment, you should dedicate significant time to understand and study the companies you are trading and the overall stock market. Most people find it difficult to dedicate the time it takes to be successful in this competitive endeavor because they have lives outside of trading.
Individual Stock Investment Can Be Expensive
To make individual stock investments you will be required to go through a brokerage, and most brokerages charge you for each time you make a buy or a sell transaction. If you’re buying and selling shares in large quantities, then the fee is less significant, but if your buy-sell is in small quantities, then you will lose a significant portion of your returns by just conducting sell and purchase transactions.
You can get emotionally attached to the companies you’ve invested in. The emotional attachment might cause you to hold on to their stock too long and negatively affect your returns.
What are the Benefits of Buying Individual Company’s Stocks?
The biggest advantage of investing in individual companies (rather than indices) is that you have the potential to experience substantial gains in returns that would be unachievable with a diversified portfolio. In the same manner that diversification decreases potential loss, it also decreases potential gain.
For experienced traders with massive portfolio sizes, individual stock investments can be used to create a diversified portfolio of only the desirable stocks in an index. However, if you are reading this article, I assume you do not fall into that category.
In conclusion, individual stock investments are not an optimal investment choice for the average person because they carry a large amount of risk that you are typically not compensated for through higher returns. You will likely have a better performing portfolio, and spend significantly less time managing your money, by simply buying into index funds (like ETFs). For more info on how to get started in ETF investing, click here for my beginner’s guide. If you'd like too generate a free portfolio custimized for you in under one minute, check out our ETF portfolio builder tool.
Note: The information provided must not be taken as investment advice. Not all information is correct. The information is presented “as is” for informational purposes only.