Many investors choose to purchase their own stocks. However, don’t underestimate the value of professional help.
First, understand that the average return in the stock market is around 10%, which trumps the 1% management fees that most investment companies will charge. The average individual investor returns just 2.6%. (J.P. Morgan)
With that said, if you still want to choose your own stocks – perhaps you just aren’t ready to work with a professional yet – be sure you account for these three risks:
- Behavioral Risk
- Price Risk
- Concentration Risk
We have referenced this book countless times and for good reason: Simple Wealth, Inevitable Wealth, by Nick Murray, goes deep into the risk associated with investor's behavior. If you haven’t read it, check it out.
Many beginner investors especially, don’t understand that volatility in the market is normal. Sometimes the market goes up and sometimes the market goes down.
Sure, it’s tough to watch 5, 10, 20% of your retirement savings disappear if the market drops. However, the true loss occurs when investors act irrationally and sell at this point. The only way you truly lose money is by selling your shares when the market goes down. By selling at bottoms.
With that said, this is only true when discussing holding a diversified investment. Many companies have gone bankrupt and the equity value has gone to $0. Thus, standard buy-and-hold advice only applies to diversified investment.
If you tread through the drops and hold onto your shares, history shows the market will go back up.
Professional advisors can help you act rationally when this happens. Financial advisors and wealth managers, more than anything, do just that. They help you manage your money without letting emotions get the best of you. They can help you act rationally, even when times get tough. They can talk you through those scary times when the market drops.
Take a look at this study. From 1990-2010, the unmanaged S&P 500 Index earned an average of 7.81% annually. The average equity investor earned, on average, only 3.49% over the same time period. To put that into context, over 20 years, a $100,000 investment would grow to nearly $450,000 if compounded at 7.81%. However, if compounded at 3.49% over the same period, the investment would grow to $198,000. (Investopedia)
Concluded from this study, the difference in performance “was most affected by the fact that investors were unable to manage their own emotions and moved into funds near market tops while bailing out at market lows.” (Investopedia)
A tale as old as time – well, as old as the stock market. Don’t let your behavior get in the way of making rational investment decisions.
Simply stated, price risk, is the risk that the price of a security will drop.
For example, if company A is selling shares at ‘X’ amount, but some uncertainty arises following the release of some new technology (or whatever they produce), there is risk that the price of the shares may drop.
Price risk is generally handled better by a professional depending on how much time you have to vet your own stocks. In our previous podcast episode, Zak discusses how much time should be spent researching companies you already invest in or may plan to invest in.
If you don’t have time to maintain your own stocks and do the appropriate research, especially on companies with smaller market cap, you are probably more susceptible to failure because of price risk.
Concentration risk is pretty much as it sounds – your stocks are concentrated. An example of this would be in a mutual fund; if you have a stock that represents over 10% of the value of the mutual fund, the fund is less diversified and more concentrated. Even getting up to 5% of the value is uncommon.
Most mutual funds may have 50+ companies all valued below 5%.
When you put all of your money into one company you risk that company going out of business or taking a substantial loss. When the stock market dropped 20% in 2018, that was the average of all of the companies in the market. Some companies dropped much more than that. Even some blue-chip stocks took a big hit.
On top of that, companies can – and do – go out of business. That’s just part of the business cycle. It’s rare that a company’s stock will hit zero, but it can happen, and you don’t want all of your money in that company if it does.
A small side note: no company in the Dow Jones has been there for more than 100 years. The last company to be in the Dow Jones or over 100 years was recently kicked out for poor performance.
Things change. Companies grow and shrink and completely dissolve. Concentrating all of your stock in one company, or even one industry, is a risk that many investors may face without help from a professional. Many people should not choose individual stocks; the average return of the market is generally enough to address your financial goals.
We’re not saying you have to go out and seek professional guidance right this second, but if you do choose your own stocks, make sure you are aware of the risks that are associated.
As a quick reminder, manage your behavior. If the stock market drops and the value of your stocks start going down, this doesn’t mean sell. Understand price risk, which is simply the risk that the price of a security will drop. And finally, stay mindful of concentration risk. Don’t put all your eggs in one basket.
If you want to hear more on the risks associated with purchasing your own stocks, check out the Mind of a Millionaire podcast.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
No strategy assures success or protects against loss.
All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Investing in mutual funds involves risk, including possible loss of principal.
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