We understand where you are coming from. You see the returns on individual stocks (in retrospect) and you want a piece of that action. The advice given by the grand majority of the advisors and bloggers is that you should sock all of your money away in an index fund.
So how do you determine what is right for you?
We all want the highest possible returns on our investments, but the steady historical 8% of the total stock market seems boring. Let’s take a look at what you should consider before deciding what to do with your hard earned savings.
Looking back over recent history, it's easy to pick out the winning stocks that a lucky few may have invested in. There is Microsoft in the '80s, Apple in the early '00s, or most recently the stratospheric rise of Netflix, but these huge gains would have required an early investment into these companies.
That is where the temptation lies. We want to pick these individual winners and ride that wave of enthusiasm for the stock.
Therein lies the issue. These stocks didn’t take off overnight.
The best time to invest would have been at their worst PR moments and not all of us have the gumption to invest at that time.
Using Apple as an example, their home computing division was getting handily beaten by Microsoft at every turn. Steve Jobs returned to the company that he had been fired from earlier and was greeted with little or no fanfare.
Apple looked horrible at that point.
We may be tempted to find these winners, but very few people predicted that Apple would revolutionize the personal music player market and then bring smartphones to prominence.
To Gamble Or Not To Gamble
Ask yourself if you would invest in GE right now. This company has fallen on very tough times and has negative press everyday. We aren’t saying that GE is going to turnaround, but would you trust a large portion of your life savings that it would?
No matter how much information we have, or facts, figures, and measurements, there is an air of gambling to the market.
That is why the advice is given to broaden your portfolio and minimize the risk from an individual stock or company. But by broadening your portfolio, you are minimizing the returns from that individual stock or company.
If you put $1000 into Apple in the year 2000, you would have close to 1000 shares of Apple stock.
Can you honestly say that you would have pulled the trigger on a stock that was $1 a share and all of the pundits predicted doom?
Chart source: Google Finance
That is where the gamble comes in, but you can be an educated gambler. The more information you have, the better your chances, right?
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Make Your Best Choice
Of course we want to maximize our returns, but the most important aspect we overlook is our tolerance to fluctuation.
The market is gonna move, and wiggle, and perceivably crash, so if your eggs are all in one basket, how would you handle that commotion? The good news is that unless the company folds completely, you only realize those losses when you sell. The bad news is that most investors do just that.
Individual investors are notorious about moving money when they shouldn’t. The psychology of the market movements make our stomachs quiver and give us waking nightmares as we see our money evaporate.
That is when most of us sell our shares and run to the next hot tip.
If we are being completely honest, most people are probably best suited to setting a savings amount, picking an index fund, and riding the market till the cows come home.
There is a huge “but” here though. The reason you are reading this, the reason you struggle with this decision, is because you want to chase higher returns. You want to be the Buffett.
Trust me, we all do.
No matter which investing advice you follow, you have to consider your entire financial picture before building your portfolio. Your perfect portfolio will be determined by your tolerance for risk, your ability to pick winners, and your ability to recover from losses.
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Rely On History
If we take it on faith that since 1900, the total stock index has returned 7% per year on average, then we know we can rely on those returns to some degree. It isn’t a guarantee, but it is a great guideline of what should happen.
8% is nothing to sneeze at and can be a very prosperous return on investment for the long term. As soon as you pull the trigger on the automatic deposits into that account though, the voice creeps up in the back of your mind that says you are leaving money on the table.
The voice says you can do better.
Historically that isn’t the case based on the vast majority of investors, but there is a way you can test your ability and not get into too much hot water. What I do is allocate 10-20% of my portfolio to stock picks.
Those hot tips and hunches are able to reside in my portfolio, but not to the degree of putting me in the poorhouse with a bad pick.
You are right, that will minimize the return I can get if I pick a winner, but I still get the satisfaction of making my own picks and proving I am a master investor(sarcasm intended).
The Eternal Struggle Continues
If you need to test your abilities and research prowess by picking individual stocks, then do so. Just don’t let it jeopardize your entire portfolio.
Everything in life should have some moderation and balance, and diversification is the best way to do that in stocks.
Pick your favorite index fund, then allocate some funds to individual stocks.
That way you won’t feel like you are leaving too much on the table and you won’t pull your hair out if the market takes a turn for the worst.
Author Bio: Derrick M. is a personal finance blogger and on a journey to financial independence. Based out of Omaha, NE, he writes Freedom From 40, a blog about leaving the rat race to greener pastures. Derrick has worked in accounting, taxes, and insurance, but dreams of making the leap to full time writer.