Should You Buy Individual Stocks?

Delta Airlines, 2005. Pacific Gas & Electric, 2001. WorldCom, 2002. General Motors, 2009. Lehman Brothers, 2008. Eastern Airlines, 1989. PaineWebber, 2003. RCA, 1996. Pets.com, 2000. E.F. Hutton, 1987. Compaq, 2002. TWA, 1992. Arthur Andersen, 2002. Standard Oil, 1911. Pan Am, 1991. Montomery Ward, 2000. Chrysler, 2009. Washington Mutual, 2008. American Airlines, 2009.

Maybe I should have just listed all airline carriers. It feels like more airlines have lost their shirt than kept it! The corporations listed above have either filed for bankruptcy or were swallowed in reorganization proceedings. Either way, their underlying share prices were heavily disrupted. Many investors suffered.

This blog post will look at the reasons why investors buy and hold individual stocks. Next I'll discuss a few reasons investors might want to hold individual stocks. Last, I'll scare you with a frightening statistic followed by a final comment. Note: I've had several clients ask me about individual stocks so far this year. This isn't a shot at any of them. Read the full post and you'll see why.

Why We Buy Individual Stock

Buying stock in a company gives an investor the potential to outperform the rest of the market. Humans always want to do better and improve. It's a natural desire to be bigger, better, faster, etc. Usually an investor buys stock because of something they heard on the news, a friend or family member's story of wild gains, or maybe they know something about the company and think they have some sort of advantage.

Usually nothing either magical or too disastrous happens after buying a chunk of shares. Typically nothing happens because you Can't Buy Past Performance. By the time the investor decides to buy and actually executes the trade, thousands of other investors have likely beat you to the punch. It's difficult to be smarter than the collective wisdom of millions of others seeking the same advantage.

Three Reasons To Buy / Hold Individual Stock

There might be more, but these crop up most often in my practice.

You receive stock options through your employer's benefits plan

If you're a highly compensated employee, after a few years exercised stock from option grants can bloat compared to the rest of your portfolio. The reason to exercise is you can buy the stock below the current market price. The reason you might hold it is the capital gains tax might be more than you want to stomach that year. Plus, there can be issues of ratcheting into higher tax brackets.

Inheritance

Perhaps your parents left you some money after they passed. Congrats! Even though the cost basis (any growth above this represents a taxable gain) resets on the date of death, what if you've held the stock for a few years? If your inheritance occurred during a prolonged bull market like the last 6 years, you probably have unrealized taxable gains. When you decide to sell, you're on the hook for paying the IRS their share of cap gains.

You have extra money to take excessive risk with

Very few Americans are on track to fulfill their financial goals. If you're one of the lucky (or disciplined) few that are, then there's no inherent harm if you lose out on a stock bet. Approach this one with a bit of caution; if you're not overly confident in your retirement income stream, sending kids to college, and paying for potential health / medical surprises, then you have no business taking this risk.

What Data Tells Us About Individual Stock Performance

The S&P 500 returned 12.1% for the 10-year period ending Dec. 31st, 2004. 2,781 stocks survived that time period. If your stock was lucky enough to survive, was it part of the 16% that lost money? Of that 16%, the average loss was almost 10 percent per year, which means they underperformed the market by more than 20 percent annually. This data suggests that there's an approximate 1 in 5 chance your stock didn't survive (bankruptcy or reorganization) or lost money.

Let's say you don't intend to hold your stock for a decade. Investing for just a year still carries massive risk. In 2004, the S&P 500 rose 10.9%. However, a third of the stocks that survived that year posted a negative return! The average loss of those stocks was 25 percent. In 2006, the S&P 500 returned 15.8%. Of the 6,133 stocks that survived '06, 2,414 (just shy of 40%) posted an average -30.5% return. In 2008, 25% of U.S. stocks lost on average 75% of their value. Last, in 2009, the S&P 500 gained 26.5% yet 40% of stocks posted negative returns.*

Still Tempted?

Not me... Insert Vegas analogy here. Buying individual stock can reward investors. However, the odds of success are actually much less than we convince ourselves them to be. I'd rather invest in a diversified portfolio; the most proven way to reduce the risk of underperformance. In my 12 years working with clients, I've only witnessed one client success story; he bought Netflix stock several years back. Unfortunately this isn't normal. There are so many unsuccessful stories I've lost count.

Final Thoughts

Enron, 2001. 'Nuff said...

* Thanks to Larry Swedroe's article Speculating Versus Investing and his research used in this blog post.