Today’s Hot Tip: Don’t Buy Stocks!

04/03/2008 12:00 am EST

Focus: STOCKS

Howard Gold

Founder & President, GoldenEgg Investing

The sudden collapse of Bear Stearns a couple of weeks ago taught many lessons, but the most important one for individual investors has gotten lost in the shuffle: Most of you just shouldn’t own individual stocks.

That’s right—owning individual stocks can be dangerous to your financial health. If they make up more than a tiny percentage of your portfolio, you’re taking on far too much risk and are likely to earn lower returns overall.  Some new research, which we’ll get to later, only underscores the point.

But first, back to Bear Stearns. We all know about the longtime employees who were practically wiped out because their savings were tied up in Bear stock, whose value plummeted from around $170 last year to the $10-a-share buyout price by JP Morgan Chase.

That was clearly unwise—although many of them were locked in to long-term compensation plans whose keystone was Bear stock, and over the last few weeks, they were unable to sell.

But there were also many otherwise smart, successful people who bought Bear stock voluntarily and had their heads handed to them.

Billionaire Joseph Lewis has lost practically all of his nearly $1.3-billion investment in Bear stock, a big chunk of which he put in while some top insiders were unloading almost $50 million of shares last December.

And top fund managers James Barrow (of Vanguard Windsor II, which I own) and Bill Miller of Legg Mason Value both held Bear stock in their funds. Miller, a legendary investor who beat the Standard & Poor’s 500 index 15 years in a row, was unaware of Bear’s collapse on the Friday before the Federal Reserve’s emergency rescue operation.

And yet, while Bear’s stock price plummeted from $80 to almost zero, Windsor II lost only 3.4% of its value while Miller’s fund dropped 11%.

And that’s the essence of the case against buying individual stocks.

Yes, you can hit an occasional home run with a Google or MasterCard. But it’s hard to find anywhere near the diversification you can get from a broad-based mutual fund or exchange traded fund (ETF).

That exposes your overall portfolio to much higher risk from any one issue. And even individuals who have good stock-picking skills rarely can do the necessary research to post consistently good results over time.  

“Individual investors tend to invest in a small number [of stocks] and they don’t know how to construct a portfolio,” says Jim Peterson, vice president at the Schwab Center for Financial Research.  “Professional portfolio managers control risk.”

William Bernstein of efficientfrontier.com estimates that because of close correlations between markets, even 100 carefully chosen stocks can’t match the diversification of holding just a couple of index funds and ETFs that cover the global market.

And without that broad diversification, you’re taking on much more risk.

A new study by the Schwab Center tracked the portfolios of Schwab clients who had $5,000 in household equity and whose accounts were either at least 95% individual stocks (including foreign shares and ETFs) or 95% open-end equity mutual funds.

The survey, taken over 2005-2006, produced stunning results:

The fund investors substantially outperformed the stock pickers, with less than half the risk and after all expenses.

Though it covered only two years—and the investors may have held other assets at other financial institutions—it did take in a huge number of the 3.5 million clients of Charles Schwab, about as good a sample of the US investing public as you can find.   

These pitiful results of individual stock picking don’t surprise Brett Trueman, a professor of accounting at UCLA Anderson School of Management.

“I just don’t know of any study that shows there’s [even] a subset of individual investors we can say with high confidence outperform the market [over time],” he says.

“Individuals tend to be overconfident about their abilities,” he continues. “They sell their winners and hold their losers. Individuals don’t like to lose money.”

And despite the disadvantages institutional investors face (the herd mentality, the need to invest fresh money, portfolio window dressing, style drift, what have you), individuals have an even bigger hurdle—time.

“You have to have tremendous energy to devote to the stock-picking process,” says David Swensen, chief investment officer of Yale University. “Individuals don’t have the time or the resources.”

Swensen, who oversees the Yale Endowment, which has grown tenfold over the last 20 years—including 28% gains in fiscal 2007—was a pioneer among US institutional managers in getting into alternative investments like absolute-return hedge funds, private equity, and hard assets.

And yet his high-powered investment team doesn’t even pick stocks; they choose top-notch outside managers to run the domestic and international equity pieces of their portfolios.

In his book “Unconventional Success: A Fundamental Approach to Personal Investment,” Swensen advises individuals to stick to a set of broadly diversified index funds.

“The only way you win is to develop a serious informational advantage to the rest of the market,” he says.

That’s pretty tough, although the explosion of resources over the Internet has definitely leveled the playing field. It’s hard to tell how many people use these tools, and to what extent, however.

“If you try to manage your own money and invest in your own stocks, and you don’t…do every single piece of homework necessary, you won’t beat the market, and you’ll probably lose money,” says one well-known investing guru. “If you don’t have the time or the inclination to do this work, then I’m begging you, please don’t try to invest in individual stocks.”

Who said that? Vanguard founder John Bogle? No, it’s Jim Cramer, who pounds the table for individual stocks amid the booyahs and silly hats on his weekday Mad Money show on CNBC.

That quote epitomizes the overall problem—information overload. Good, sensible advice gets lost in the hype of showbiz antics, silly stock-picking contests, endless lists of stocks that “beat” the market, amateur affinity groups whose limited track records don’t stop them from claiming to be superior investors—all the bells and whistles of today’s financial media.

(And, full disclosure, here at MoneyShow.com, we do feature experts recommending individual stocks as part of a broad offering of opinions and investor education.)

So, if you’re thinking of buying individual stocks, you first have to decide that you really have what it takes to be a good stock picker. Then you need to find reliable sources of information and follow time-tested methods of security selection, using fundamental and technical analysis. Then you need to make sure individual stocks are no more than, say, 10% of a diversified portfolio like the one I recommended here.

“Investing is fun for a lot of people, and if they want to try their hands [at stock picking], they should go for it,” says Peterson. “Just make sure that the majority of your portfolio is diversified.”

The rest of us would rather get our thrills and chills elsewhere. 

Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own and do not necessarily reflect the views of InterShow.

Related Articles on STOCKS