Diversification: Think Twice Before Investing In Individual Stocks (Content for Financial Advisors)

Use this article as a basis to explain the information to your clients. Feel free to copy and edit as you see fit.

Your individual stock choices only determine a sliver of your performance; the vast majority of your returns come from your portfolio allocation, often seen as a pie chart. Some people invest in individual stocks for the thrill. It can be a game, with emotions as volatile as the prices of underlying stocks. But you really shouldn’t be spending your time picking individual stocks unless you really are willing to spend the time necessary to follow the market, don’t mind the brokerage fees, and have allocated the remainder of your portfolio wisely to pad against potential losses.

Analyzing individual stocks is usually a job for trained mutual fund managers, investment brokers, and financial analysts. As Benjamin Graham advised in his acclaimed 1949 book The Intelligent Investor, never mix your speculation dollars with your investing dollars: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” When most people are saying something like “I have 20% of my portfolio in equities,” they are usually talking about equity mutual funds, not individual stocks.

Let’s look at why the vast majority of investors invest in equities through funds, not individual stocks:

It’s not easy. Investing in individual stocks without the time or training necessary to perform fundamental analysis can cause you to jump in when at or near the peak of the stock’s performance. If you found a stock in a list of “hot” stock tips, it is likely that its growth phase is at or near decline.


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Sell discipline. Many investors have difficulty applying a strict sell discipline when investing in individual stocks. Emotional reasons make it hard to part with a stock that’s “treated you well” even as the justification that you had to purchase it in the first place is long gone. Furthermore, when a new holding starts falling immediately after purchase, many investors will root for the stock to “turn around” even though there is no justification for such a move.

It lacks diversification. The reason that mutual funds, index funds, and ETFs are less volatile than individual stocks is not just that choices are made by trained professionals; it is because profits and losses are diversified. An index fund which follows the S&P 500 owns stock in 500 different companies. If the price of one of the stocks drops significantly, the entire fund will be relatively unshaken. You can purchase 20-30 individual stocks for a similar level of diversification (yes, you get close to no benefit from owning more than 30 stocks) but actively managing a portfolio of 30 individual stocks will ring up brokerage fees and time. [1] Index funds and ETFs allow you to diversify relatively inexpensively, and lowering fees is key to generating higher returns.

Counterintuitively, the better you do in the market, the riskier your portfolio becomes. This is because the better you do, the higher the percentage of your total portfolio is in stocks. Thus, even if you initially only wanted 10% of your portfolio to be made up of individual stocks, the more your stocks grow, the higher the percentage of individual stocks in your portfolio. Not only does the entire percentage of stocks in your portfolio increase when a single stock goes up, but so do your holdings in that stock, and, consequently, your risk exposure. This is why rebalancing each year is recommended. Don’t fall in love with a stock. If you just did really well, sell some stocks and rebalance.

We recommend that instead of investing in individual stocks, you choose low fee ETFs and index funds that closely follow indexes such as the S&P 500 or the Russell 2000 to fill the quota of equity in your portfolio. You’ll sleep better at night and have more time to enjoy other activities in life, those beyond just making money.

But if you’re still determined to invest in individual stocks for profit instead of fun…

Try a stock screener. A stock screener neither selects winning stocks, nor keeps you focused on long-term goals. It does not screen more information than that which is contained in its databases, nor make any real predictions or absolute judgments. It merely links to a data source and sorts information based on the statistics you select. However, if you would like a quick way to choose which stocks are performing well and which companies are currently robust and which ones are failing, stock screeners are a great place to start to help narrow your list and save you time.

A stock screener is a tool for narrowing a long list of stocks into a smaller list by numerous criteria such as Industry, Sub-sector, P/E ratio, Market Capitalization, Dividend Yield, Performance, Revenue, Margins, Valuation, Growth, ROE, etc. Free online stock screeners appear on Google Finance [2], Yahoo Finance [3], MSN [4], Daily Finance [5], CNBC [6] and Morningstar [7], and some low-cost stock screeners are available from iClub Software [8] and Manifest Investing [9]. When choosing which stock screener to use, you should consider how many and which stocks the screener covers, the selection of financial metrics it allows you to a screen using, as well as the clarity and timeliness of the data.

[1] http://www.investopedia.com/articles/01/051601.asp
[2] http://www.google.com/finance/stockscreener#c0=MarketCap&c1=PE&c2=DividendYield&c3=Price52WeekPercChange&region=us&sector=AllSectors&sort=&sortOrder=
[3] http://screen.yahoo.com/stocks.html
[4] http://moneycentral.msn.com/investor/finder/customstocksdl.asp
[5] http://www.dailyfinance.com/investing/stockscreener/
[6] http://www.cnbc.com/id/15839076/site/14081545/
[7] http://screen.morningstar.com/StockSelector.html
[8] http://www.iclub.com/products/NAIC_Stock_Analyst.asp
[9] http://www.manifestinvesting.com/