Are Individual Stocks too Risky?

The allure of finding the next Apple, Microsoft, or Amazon often entices investors into owning individual stocks instead of a broadly diversified portfolio.  Is that wrong or is there a place for that when investing? Below are two considerations when deciding on whether to invest in individual stocks.

#1 Unpredictable Planning – Owning individual stocks creates the opportunity to significantly outperform or underperform the broader market. Because of that, planning becomes extremely difficult since you can’t rely on the weighty evidence of history to make assumptions.

Example – Joe needs $2,000,000 in 10 years to retire. He has $1,000,000 saved already and $250,000 of that is in the stock of the company he works for. If he earns 7% per year (not guaranteed) and saves $15,000/year, he will have his $2,000,000.

However, if the company goes out of business, and the stock goes to $0, while the other investments earn 7%, he would need to save over $50,000 a year (and also need a new job). On the other side, if the company did twice as well, earning 14% per year, he wouldn’t have to save anything! That makes planning much more difficult!

#2 Creative Destruction – Joseph Schumpeter made this term popular in the 1940’s. The premise is that new innovations eliminate the old. So when you bet on an individual company you have to bet on them over and over again to innovate and stay ahead of the competition. Over time, great companies often make room for newer and brighter ones. When you own the broader market, you get a piece of it all.

If you do want to own individual stocks, I would suggest the following:

• Invest only what you can afford to lose
• Price matters – You can buy great companies at too high a price and get terrible returns. Just ask the people who owned McDonalds or Coke in the 1970’s.
• Own companies that you would feel comfortable going away on vacation for 30 years without being able to check on them.

Disclaimer: All references to bonds refers to US long-term government bonds and all references to stocks refers to dividends plus capital gains on a broad based capitalization-weighted index of U.S stocks.  Alex Voorhees and Reston Wealth Management do not provide legal, accounting or tax advice. This information is not intended to be a substitute for specific individualized investment, tax or legal advice. We suggest that you discuss your specific situation with a qualified investment, tax or legal advisor. The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) or strategies may be appropriate for you, consult your financial advisor prior to investing. No strategy assures success or protects against loss. You should consider the investment objectives, risks, charges and expenses of any investment carefully before investing. You cannot invest directly in an index.