Yahoo Finance Do You Have the Stomach to Be a Stock Investor?
There are plenty of decisions to make when allocating your investment portfolio, but one of the first should be whether to buy individual stocks or mutual funds. Fund proponents cite diversification as a key benefit. With a fund, or multiple funds representing different asset classes, risk is spread among a range of securities. If one holding in a fund suffers a sharp decline, it's offset by better performers.
On the other hand, proponents of holding single securities often like the idea of beating an index, or getting into a new or small company earlier than the crowd. Other times, stock investors like the story and prospects of a large, established company, such as Apple or Johnson & Johnson.
Some investment methodologies favor one approach over the other and have strict rules about portfolio construction. However, in practice, many portfolios contain a mix of funds and individual securities. How should individual investors decide whether to choose stocks or funds, and, if using both, how should they allocate? Professional asset managers recommend specific strategies for determining portfolio allocations. They emphasize that investors must tailor their strategies to match risk tolerance and time available for stock research.
Elyse Foster, founding principal of Harbor Financial Group in Boulder, Colorado, constructs client portfolios using mutual funds and individual securities. Her investments are selected with an eye toward how well the pieces of the puzzle fit together. When choosing funds, she recommends investors understand which areas of the market and which asset classes to include. Those choices depend on factors such as investing objective and risk tolerance.
Foster uses a combination of actively managed and index funds to achieve the desired balance, and evaluates funds using yardsticks such as expenses, management team and performance. Her portfolios also include around eight to 10 individual stocks, selected with a buy-and-hold strategy in mind. "Our criteria are that they be primarily market dominators -- companies with wide moats and good, consistent, long-term management. We separate them over sectors. We might have a tech pick, a health care pick and then picks from other sectors," she says.
Foster cautions that investors need a plan for buying and selling individual stocks. "You have to do proper research before your purchase, and you have to have a purchase methodology and a selling methodology before going in," Foster says. "For example, you might say, 'I'm going to sell this position when it doubles in value.' Or use the Warren Buffett methodology, which is: The best time to sell a stock is never."
Ramesh Gulati, founder and chief investment officer at Gulati Asset Management in Vero Beach, Florida, says for many investors, the decision to sell a stock can be more difficult than the decision to buy. "People get married to an individual stock much more easily than with a mutual fund or exchange-traded fund," he says. "A lot of times, with funds and ETFs, selling is only done when the money is needed. With individual stocks, you have to be more savvy and understand when to cut your losses or when to say, 'I'm not going to be too greedy. I'm going to take my profits and move on to another stock.'"
Gulati, who uses a mix of indexed ETFs and individual stocks, says investors inclined toward single stocks should begin with an allocation of 75 percent to 80 percent in ETFs. The remainder can be put into in stocks. "Invest in five different companies from five different sectors that you think are the best -- things that you use and would enjoy following and keeping up to date with," he says.
From there, Gulati recommends tracking the performance of the individual stocks against the performance of index funds. If the individual stocks are outperforming the indexes, gradually shift more money away from ETFs and into single stocks. "During that time, you're also educating yourself and getting more comfortable and confident in choosing the individual stocks," he says.
Gabriel Wisdom, founder and managing director of American Money Management in Rancho Santa Fe, California, wrote a book on single-stock investing, "Wisdom on Value Investing: How to Profit on Fallen Angels." However, that doesn't mean he advocates for investing in individual stocks in every situation. "You use mutual funds when it's just too difficult to select the stocks that are on sale, that would be attractive, and should be rewarding over time," he says.
In particular, he cites the example of emerging markets. Not only can it be challenging for U.S. investors to properly research emerging market equities, but those stocks are often not available domestically outside of a fund. "There are times when emerging markets are extraordinary opportunities for people who have a reasonable time frame and are willing to wait two or three years," he says. "China was on sale a couple of years ago, and last year it was one of the best-performing emerging markets. But which Chinese companies do you select? A mutual fund manager who understands that market would be worth paying for."
Russia, where stocks are currently beaten down, is another example of a country where American investors may find opportunity, Wisdom says. Again, he recommends investing in a mutual fund or ETF rather than trying to cherry-pick companies unfamiliar to most Americans. When it comes to selecting individual equities, Wisdom's fallen-angel approach zeros in on companies that are out of favor for various reasons. "'Fallen angels' is an old Wall Street term to describe stocks or bonds that have fallen from grace," he explains.
This fall can occur because of normal business and economic cycles that cause stocks to drop across the board. Another reason would be a company-specific misstep that causes a stock-price decline. Finally, stocks may be deemed "fallen angels" after a marketwide panic, such as in 2008.
Wisdom, who is a private pilot, suggests using a checklist to verify whether a stock meets certain purchase criteria. "Every pilot has to use a checklist. There's nowhere to pull over in the sky," he says.
The investor's checklist should consist of fundamental factors, such as the return on equity, profitability and debt levels. It should also include valuation metrics, such as price-to-earnings and price-to-sales ratios. "It's not easy for an individual investor to know when a stock is cheap or when it's expensive just based on share price," Wisdom says. "A company selling at $100 per share can be very cheap, and a company selling for $10 a share can be very expensive. It's all based on things such as revenue, earnings and market capitalization."
Elyse Foster also emphasizes the need to research investments thoroughly, and adds that not everyone is suited to buying single stocks. "Individual investors need to know themselves, and know whether they're interested in doing this research and monitoring, and whether they have the time. A really busy person may not have time to do this research," she says. "But if you have a proclivity for it, if it's fun and interesting for you, you can do well with individual stocks."
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