At Whitaker Myers Wealth Managers, we aren’t shy about the importance of portfolio diversification. Because fund-based investing is great for diversification, it’s generally a widely used strategy among investors looking to spread their money to many different companies. The reality with the fund-based approach is that the fund's performance is ultimately tied to the performance of individual stocks – they’re just surrounded by an entire bracket of other stocks that help protect you from having too much weight in one company. However, some investors like to increase their exposure to certain companies by including individual stock positions inside their investment portfolios. This article will explore the risk vs. reward relationship that individual stocks have within a portfolio.
You might occasionally turn on CNBC or Fox Business and hear about an individual stock that is taking the world by storm. If you’ve ever wondered what makes a good stock pick, it's important to understand that loads of research and analysis go into any investment recommendation. Timing the stock market is hard enough for professional day traders (which we don’t presume to be), but picking a company whose stock is a sure bet is like finding a needle in a haystack. There is an argument for including individual stocks in a portfolio, but shooting from the hip is not advisable, and doing so requires prudence.
The Risk of Individual Stocks
In 2020, you may remember a small number of individual stocks that grew in popularity seemingly overnight. Stocks like this were all over the news (and social media feeds) because of their rapid increase in stock price in a short amount of time. Some everyday investors made a small fortune by getting into and out of those positions at the right time. As people flocked to brokerage accounts to get in on the action, many missed the boat and were left on the wrong side of a flash-in-the-pan investment. This highlights the danger of emotionally driven investing and the inherent risk of putting all your eggs in one basket. If the bottom falls out, you have a mess on your hands and no breakfast to boot.
Of course, this is an extreme example of what can go wrong when buying individual stock. An important part of investing is being committed to the process, which, in many cases, is a long time in the making. A far more common outcome is missing out on long-term sustained growth by being too heavy in a company that struggles or eventually fails. The inherent risk is known as company risk. When you have exposure to an entire index like the S&P 500 for your growth and growth and income exposure, you won’t lose sleep if one of those companies struggles for a sustained period of time because that one bad apple is buffered by a basket of surrounding stocks in the fund. If, however, you make the risky decision to put a significant portion of your portfolio into one, two, or even a dozen companies, and a few of them struggle, that could create problems that you feel for a long time.
Individual stock investing is risky, but with that being said, there are ways to include that strategy in your investment portfolio.
The Reward of Individual Stocks
It’s important to note that, while not appropriate for everyone, individual stock exposure has some surefire benefits.
If done correctly, your stock exposure can mirror your fund-based strategy through something called Direct Indexing. Our Chief Investment Officer, John-Mark Young, wrote an article last year about Direct Indexing, which gives you many of the benefits of fund-based investing, namely diversification, but gives you the ability to sell individual stock positions at a loss to tax-loss harvest, helping you defray any realized capital gains in the account. This can be a significant benefit if you’re a high-income earner and need help lowering your tax liability.
More Cost-Effective
Think of stock investing as an added layer to your investment strategy. Coupled with your fund-based investments, any individual stocks can add sustained appreciation to your portfolio, which is also true for your fund-based investment. Individual stocks do not carry an expense ratio, which is an annual fee charged by the fund companies to the investors in the fund. By utilizing strategy, an investor can potentially save some money, especially when you’re talking about holding onto a position for an extended period of time. Stocks can have front or back-end loads, but they only come into play when a buy-and-sell transaction occurs, unlike an expense ratio that can hit annually.
In general, individual stocks allow investors to be tactical and specific with how they are investing. If you have specific criteria surrounding companies you will and will not support, then buying individual stocks may be the best way to ensure your standards are being upheld. Funds exist that do much of that screening, but the more specific an investor’s needs, the harder it can be to find an appropriate fund(s).
Investing in individual stocks can offer some benefits to an investor's portfolio strategy, but it is important to consult with a financial advisor to help you determine if it’s right for you. If you do not have a financial advisor, contact one of our team members to help answer any questions you may have.
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