Individual Stocks: Speculative Bet or Prudent Investment?

I remember the first stock I bought (35 years ago) at the age of 13 was Apple computer. It would be worth a zillion dollars by now if I had just held onto it. You know who else did not hold on to his Apple stock? Steve Jobs! He sold all his shares (except 1) when he resigned from the company in 1985. He would have been the richest man in the world at the time of his death if he had not sold his stock.  Individual stocks are where fortunes are made…and fortunes are lost.

Why is successful investing in individual stocks so difficult?

People like to point to the amazing performance of an Apple or Amazon and say “if only”…if only I had bought that stock and held it for 20 or 30 years. However, for every home run there are hundreds of stocks that have average performance, under perform, or go bankrupt. It’s like finding the proverbial needle in a haystack to find a home run stock in the first place, but then holding it for 20-40 years may be even more difficult.

Let’s use Amazon as an example:

Amazon is an incredible success story. It was the 3rd best performing stock for the 20-year period from the time the company went public in 1997 to the beginning of 2017. One of the only two stocks that outperformed it over that timeframe was Monster Beverage Company. Who knew? Anyway, if you had $1,000 invested in Amazon at its IPO, it would now be worth over $865,000 (as of March 27, 2018).

Source: https://bit.ly/2vDngrT

The point I want to make here is very few individual stockholders held onto their Amazon stock from 1997 to the present day. The ride has just been too gut-wrenching for individual investors, as Michael Batnik pointed out on his Irrelevant Investor blog: Some of the losses Amazon has experienced along the way have been totally insane. It fell 15% in just three days 107 different times; it has lost 6% in a single day 199 times, and it fell 95% from December 1999 to October 2001.

Check out the chart below. The red lines show the peak to trough decline in Amazon stock during each calendar year. The black line shows corresponding intra-year decline for the Dow Jones Industrial Average.

Source: https://bit.ly/2hQPJId

Some Stocks Don’t Bounce Back

Amazon might seem like an obvious success story in hindsight, but many once hot companies never bounce back. Check out his chart from Research in Motion (maker of the Blackberry smartphone):

Source: https://bit.ly/2I11y8G

Pets.com, eToys, and Groupon are a few other examples of stocks that led to regret among buy and hold investors. Pets.com and eToys went bankrupt, so investors who rode those into the ground lost 100% of their investments. Groupon is still operating, so it is a good example of a company that seems like it should be a good investment but has not been. Groupon was launched in 2008 and grew to $1 billion in sales faster than any company in history. It went public in 2011 at $20 a share and briefly traded at $28. The stock went into a downward spiral shortly thereafter and is now under $5, despite having a more attractive valuation (lower Price to Earnings ratio) than Amazon.

Big, stable, iconic American companies can also go through very long periods of underperformance. General Electric, for example, was one of the best stocks of the 1980s and ’90s, with a 23.6% annualized return. That means $1,000 invested on January 1, 1980 would have grown to over $69,858 by December 31, 1999. However, if you held on to your GE stock since January 2000, your $69,858 would have lost more than half its value over the past 17 years (to $31,375).

Source: https://bit.ly/2I11y8G

Mutual Funds and ETFs vs. Individual Stocks

Three problems exist for most investors who pick individual stocks:

  • Stocks take a lot of time to research and follow.
  • It’s almost impossible not to let emotion affect your investment decisions, and
  • Most retail investors who trade individual stocks have too much of their portfolio invested in too few stocks. Concentrated positions can be devastating to your financial security when they go against you.

You will never hit an Amazon type of home run if you invest in mutual funds or ETFs, but you are much more likely to avoid the big mistakes that derail most investors. Mutual Funds and ETFs are more practical for most people because they diversify your exposure among a basket of companies.

Investors who want to use individual stocks can limit their risk in several ways. The most important risk management tool is position size. We recommend limiting exposure to any one company to no more than 5% of your investment portfolio. Any more than that means that your investing is a more “speculative bet” than prudent investing.

Thoughts, questions, comments? Send me an email.