Investing is one of the most important things you can do to reach your financial goals. However, a lot of people don’t have a clear understanding of the stock market or how to create a safe, reliable investment strategy. Indeed, for many individual investors, the stock market can feel like the Wild West, full of unpredictable risk and reward. Part of the reason the stock market can feel so unpredictable is because many people equate investing with investing in individual companies.
However, single stock investing is one of the riskiest investment strategies out there. Indeed, if you talk to almost any professional investor, they will likely caution you against this strategy.
In this post, I’ll go over why individual stock investing is a bad idea for many investors. I’ll then discuss which financial products are better for most people’s risk tolerance and financial goals.
The Risks of Investing in Single Stocks
Single-stock investing can seem exciting. Many of us remember news stories about people making it big by investing in the right company at the right time. Some of us may even know people who hit it big investing in a single company. My grandparents seriously scored when they invested in companies like Coca Cola many decades ago.
However, owning even a handful of individual stocks comes with huge risks and downsides. For most of us, that investment strategy won’t work out well in the long run. Why is that?
Lack of Diversification
First, this strategy involves a lack of diversity in your investments. Most of us aren’t wealthy enough or have enough time to own different stocks in hundreds of different companies. So for most of us, investing in individual stocks means our investment returns will be based on the performance of a handful of companies.
This sucks because that handful of companies can be affected by a million things that are impossible to predict. For example, you might have invested entirely in companies in the U.S. or large companies. A policy change could hit all those companies in similar ways. Likewise, a horrible event like 9/11 or COVID could affect your investments in similar ways.
Plus, an idiosyncratic change in one company—like a CEO who gets fired, a product recall, or simply a product launch that didn’t go as well as expected could all tank a big chunk of your investment portfolio.
This is why you want your investment portfolio to include a wide range of companies in diverse industries and locations. Doing so means that a particular event is unlikely to affect the businesses you invest in in the same way. In fact, if your portfolio is diversified, you might notice that small companies do well in response to something like a policy change while large companies do poorly. As a result, you may your overall investments may do okay because you’ve included both types of businesses.
Higher Risk Without Extra Reward
Because of the lack of diversification, investing in an individual company or group of companies comes with high risk. And, for the most part, these risks don’t pay off in terms of better rewards than if you were to diversify your portfolio.
These risks also play an important role in investment withdrawals. The stock price of an individual company tends to be quite volatile. As a result, you may struggle to know when the best time is to take your money out of the stock market. If a company’s stock has been going up, people tend to leave their money in that stock for too long under the expectation that it will keep going up. If a stock goes down, people also tend to leave their money in that stock too long in the hope that it will increase.
This ends up meaning that, because of people’s emotions, they rarely sell their stocks anywhere close to when they would earn the most money. It’s easier to remove your emotions from the buying and selling process when you have a bundle of safe, reliable stocks that tend to increase in value at a steady rate.
Expert Level Financial Knowledge Required for Investing in Single Stocks
An additional problem with this strategy is that it requires hours of research to pick good stocks for you. When you own individual stocks, it’s important that you analyze the stock’s past performance, the company’s financial health, whether the company is deemed over-valued or under-valued, and so much more.
As a new investor, this kind of knowledge has a steep learning curve. Plus, most of us don’t have a lot of time to become financial experts.
The Role of Real Estate
The discussion above focuses on stock investing. You may wonder how investing in real estate fits into this.
In some ways, investing in real estate is similar to investing in single stocks. This is especially the case if your main investment is the property you live in or if you are investing in just a few properties. Similar to how a company’s stock price can tank for variety of reasons, housing and rental prices can also drop unexpectedly. We’ve certainly seen this recently. If your real estate investments are all in the same geographic area or all the same type (like apartments, condos, or single family homes), you increase your risk.
Plus, you might experience unexpected repairs and phantom costs that majorly eat into your returns.
This is not to say that real estate is a bad investment. However, you should view it as one component of your investment portfolio. To ensure you’re well-diversified, make sure that the majority of your assets aren’t tied up in a single kind of investment. Instead, spread your investments across a wide variety of locations, industries, and company sizes. I’ll describe an easy way of doing this below.
Alternatives to Investing in Single Stocks
The above represent a few key reasons that you should avoid investing in single stocks, especially for things like your retirement accounts that you will depend on in the future. Luckily, there are lots of great investments that involve less risk and higher average returns than most individual stocks.
Mutual Funds: The Higher Cost Investment Option
Mutual funds generally include a wide range of stocks from different companies. Because of that, they help build a diversified portfolio. Some of these mutual funds also fit into particular categories. For example, you might have a mutual fund based on environmentally-friendly investments or large businesses.
Mutual funds are actively managed by financial professionals. Given that, they come with management fees that make them a higher cost option than some of the options described below.
Index Funds and Exchange-Traded Funds (ETFs): Lower Fees and Better Returns
Similar to mutual funds, index funds and ETFs represent a collection of stocks. They too can fit into particular categories. For example, one of the most popular index funds/ETFs is an index fund/ETF based on the S&P500. These index funds/ETFs include investments from the 500 largest companies in the U.S. They update themselves as companies grow and shrink and so enter and leave the S&P500. There are also index funds based on emerging markets, small businesses, different industries like technology companies and more.
Unlike mutual funds, index funds and ETFs are largely not actively managed. Companies enter and leave as they fall into and out of particular categories. This means that these investments are passively managed. Given that, they come with lower fees. Moreover, index funds and ETFs often have the same or higher returns than mutual funds. Consequently, many financial advisors recommend them over mutual funds.
Index Funds vs. ETFs
What’s the difference between index funds and ETFs? ETFs have some tax advantages that are honestly too boring to describe. The important point is that ETFs generally come with slightly lower capital gains.
However, investing in index funds, ETFs, or both is an easy way of building stable, long term investments without much risk. They are also some of the best investments for your retirement accounts. Just remember that you will likely want to invest in at least a few different index funds or ETFs so that you can further diversify your investments.
For example, you might want to invest in a low-cost index fund based on the S&P500, an index fund based on small businesses, and an index fund based on emerging markets to really spread out your risk. A financial advisor can help you make the best investment decisions for you.
When Can You Invest in Single Stocks
Investing in single stocks can be a really fun option. As mentioned above, it’s easy to get emotional about single stocks. This can be a problem for making big financial decisions. At the same time, without emotions tied to our investments, it’s hard to get excited about them.
Consequently, if you have a little extra money you are okay with losing, you can invest that money in single stocks. Financial advisors frequently call this “play money.” Investing a little play money can be a good idea for getting you excited about investing. The important thing is to keep these investments to less than 10% of your portfolio and ideally closer to 5%. This way you won’t be over-exposed to the risks mentioned above and potentially lose too much of your hard-earned money.
If you plan on investing in single stocks and especially if you don’t have much money to invest, look for brokerage accounts that offer fractional shares. This means you can buy a partial share of, say, Apple, without having to spend hundreds of dollars on a single share.
Final Thoughts on Investing in Individual Stocks
Investing in individual stocks can be a fun option for building interest and excitement in personal finance. However, you should never rely on individual stocks as the basis for your investment portfolio or retirement funds. Instead, you should view investments in individual stocks as “play investments.”
Luckily, there are many alternative investment options that are safer, more reliable, and offer better returns on average. In particular, index funds and ETFs are great options for most investors. By simply investing in a few index funds or ETFs, you can quickly build a diversified portfolio to earn you passive income for retirement and other long-term financial goals.
Want more information on investing? Check out my posts on investing for retirement, investing for beginners, and the value of investing in real estate vs. investing in stocks.
Finally, remember that I am not a certified financial planner. This information is solely provided for informational and entertainment purposes. Before making any decisions, seek financial advice from a certified financial planner.
