The Risks of Investing in Individual Stocks
Investing in individual stocks can be a tempting option, especially when you see success stories of people who picked the right stocks and made substantial profits. However, according to Christine Benz, director of personal finance and retirement planning at Morningstar, this approach is not recommended for beginners. Benz stated in a resurfaced 2020 post that “individual stocks are TERRIBLE investments for people just starting out.” This sentiment still holds true today.
The primary reason for this cautionary advice is the significant risks involved with individual stocks. While the stock market, as a whole, has historically shown an upward trend, any individual stock can experience sharp declines in value. For novice investors who lack the expertise and resources to perform proper due diligence, choosing stocks without sufficient information can lead to poor decision-making. Investing in a few well-known names may seem like a safe bet, but it exposes investors to significant dangers if those stocks perform poorly.
To mitigate these risks, Benz advocates for building a diversified portfolio using low-cost mutual funds and exchange-traded funds (ETFs). By spreading investments across a broad range of stocks, the chances of a single investment dragging down the entire portfolio are reduced. Benz believes that using broad market index funds, which aim to replicate the performance of an underlying market benchmark, is the type of investment that provides a good outcome, backed by ample data.
Building a Diversified Portfolio: Why Mutual Funds and ETFs are a Safer Option
Mutual funds and ETFs offer several advantages over investing in individual stocks, especially for beginners. These investment vehicles allow investors to achieve broad diversification without the need for extensive research or knowledge about individual companies.
For instance, an index mutual fund or ETF that tracks the S&P 500 provides exposure to around 500 stocks. Since these funds aim to replicate the performance of a market benchmark, they help investors participate in the overall growth of the market. Additionally, these funds often come with low or no annual fees since they are not managed by high-priced professionals.
By investing in mutual funds and ETFs, young investors can reduce the risk of substantial losses due to the poor performance of a single stock. Instead of relying on the success of a few handpicked companies, they can benefit from the collective growth of a diversified portfolio.
Lessons Learned: Using Stocks as a Learning Tool
Sharp declines in stock prices can serve as valuable lessons for investors. Experiencing the visceral emotions associated with market volatility and witnessing the consequences of poor investment choices can provide valuable insights. However, according to Benz, one doesn’t have to subject themselves or a young investor to the risk of major losses to learn these lessons.
Instead of investing in individual stocks, Benz suggests looking at the top companies in an S&P 500 index fund. Discussing these companies with young investors can generate excitement and help them grasp the concept of being a business stakeholder without the risk of significant financial losses. The current top five stocks in an S&P 500 index fund are Microsoft, Apple, Alphabet, Amazon.com, and Nvidia.
While owning a single stock may be more thrilling than owning an index, Benz considers a small investment in a company a young person likes or understands as an acceptable approach to imparting a lesson about stocks.
Balancing Act: Incorporating Individual Stocks into Your Investment Strategy
While Benz advocates for beginners to focus on diversified portfolios, she recognizes the allure of owning individual stocks. She suggests that investors allocate around 90% of their investments to a broadly diversified portfolio. By doing so, they can maximize the chances of steady returns while minimizing the risk associated with individual stock volatility.
According to Benz, allocating the remaining 10% of investments towards individual stocks can provide an opportunity to dabble in companies that investors are particularly interested in or have strong faith in. This approach maintains the majority of investments in safer options while allowing for the thrill and potential rewards of picking individual stocks.
Making Smart Investment Choices: Tips for Young Investors in 2024
For young investors looking to start their investment journey in 2024, the key is to focus on building a well-diversified portfolio. Investing in low-cost mutual funds or ETFs that replicate the performance of market benchmarks, such as the S&P 500, can be a smart choice. These funds offer broad exposure to multiple stocks and come with lower fees compared to actively managed funds.
It’s essential for young investors to understand the risks associated with investing in individual stocks and the potential for substantial losses. By spreading investments across various stocks, they can minimize the impact of poor-performing stocks on their overall portfolio. This approach positions them for long-term growth and reduces the odds of being severely impacted by the performance of a single stock.
While young investors may be enticed by the allure of individual stocks, it’s essential to exercise caution and limit exposure to a small portion of their portfolio. This way, they can strike a balance between engaging in the excitement of stock picking and building a solid foundation with diversified investments.
As the year progresses, it’s crucial for young investors to stay updated on market trends, seek reputable advice, and remain committed to their long-term investment strategies. With patience and a diversified approach, they can navigate the market’s ups and downs and potentially achieve significant growth over time.
Analyst comment
Positive news: The article provides valuable advice for beginners on the risks of investing in individual stocks and the benefits of diversifying their portfolios with low-cost mutual funds and ETFs. It emphasizes the importance of learning from market volatility and suggests ways for young investors to engage with stocks without risking significant losses.
Market analysis: Young investors should prioritize building a diversified portfolio with low-cost mutual funds and ETFs that replicate market benchmarks like the S&P 500. By minimizing exposure to individual stocks and focusing on broad market investments, they can reduce the risk of poor-performing stocks dragging down their overall portfolio. Staying updated on market trends and remaining committed to long-term investment strategies will be crucial for potential growth.
