3 Reasons Not to Invest in Individual Stocks
Nvidia (NVDA) is a market leading chip manufacture helping to power gaming systems, driverless cars, artificial intelligence, and servers. In the last year, the stock price rose over 80% on news of the proposed purchase of ARM holdings, a company that could help Nvidia supply chips in cell phones. In addition to this news, Nvidia stock split on July 20th, in theory to help attract younger Robinhood investors.
As everything becomes more computerized, there is no doubt that chip designers and manufacturers will be in more demand than ever. So it makes sense to invest in them, right? Not for me. Why not? The answer is the same reason why I would not buy individual stocks and it all comes down to three things: diversification, information and time.
Why Diversification is Important
When building an investment portfolio, holding one or even five stocks is not enough to completely diversify your money. The less diversification that you have, the more investing looks like gambling. A portfolio with somewhere between twenty and thirty stocks can be deemed diversified. I will also add that each stock should not be greater than 5% of your total investments and ideally, each company be in a different industry. Owning five companies all in chip design does not count as diversification.
I tend to be more cautious, so let’s say I find thirty companies to invest in. After doing my research I have to pick what I think are the best performers going forward. This is where investing goes wrong, even for professional fund managers. S&P reports that over the last five years, 75% of fund managers underperformed the S&P 500. Of the 25% that have performed better than the S&P 500, only 33% were able to continuously outperform for three years or more in a row. This means that there is less than a 10% chance that professional managers have the ability to outperform the S&P 500. After all that work searching, purchasing, and monitoring my thirty stocks, I would have to achieve what most of the best money managers in the country can’t do – beat the S&P 500 index. Oh, and if we look out 20 years, only 1% of fund managers actually beat the S&P 500 after fees. This means that all your friends that are picking their own stocks and telling you how great they are doing are, statistically speaking, are either poor at math or lying.
In an efficient market, we are all getting stock information at the same time and can equally react at the same time. This is not the reality for small firms and individual investors. All too often, large players in the game are able to get ahead of the little guy in reacting to company news. This disadvantage can be reduced by focusing more long term on the stock, but the reality is short term volatility can be hard to withstand when so much of the portfolio’s performance depends on each stock’s performance, especially in my example of thirty holdings above.
Investing Takes Time
As a finance major in college, I had lots of time to track stocks. I was even the president of the investment group where we managed 100k in an E*TRADE account. Now, running a rapidly growing wealth management firm, tracking individual stocks sounds daunting. We still have to monitor individual stocks when necessary, but our best use of time is developing and monitoring in-depth client financial plans. Great estate and tax strategies, timely portfolio rebalances and keeping a client focused long term add much more value than trying to be the 1% manager that outperforms the S&P 500 year over year.
Managing assets using broad index funds is hard to beat long term. Yes, there will always be short term investment strategies that will make a quarterly statement glow, but the reality is that it is statically impossible to sustain. The average index is not so average when nobody can beat it. Focus on planning and let a low-cost index portfolio do all the heavy lifting long term.
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