Should you buy individual stocks?

Before you go out and start buying stocks on your own, let me say that not everyone should invest on their own. Only those that Ben Graham called ‘enterprising investors’ should do this. Those that fit in the category of ‘defensive investors’ should only own broad-based index funds or ETFs.

If you are not willing to spend at least five hours per week on your investments, then you are a defensive investor. If the thought of losing large amounts of money scares you greatly, then you are a defensive investor. If you do not know anything about investing and do not want to take the time to learn, then you are a defensive investor. If the thought of making a fortune in the stock market makes you giddy, then your emotions will interfere with your intellect, and you would be better off as a defensive investor.

There is nothing wrong with being a defensive investor. There is more to life than investing. If you fit the profile of a defensive investor, then stick your money in a low-cost stock index fund (such as those run by Vanguard). I particularly like Vanguard’s target-date funds. You will not beat the market, but you will do about as well as the market as a whole, and you will have plenty of time to enjoy life.

Now, for those of you who fancy yourselves as enterprising investors. Picking stocks is not for the faint-hearted. There will be times when your stocks will decrease in value. You will need the courage to either hang on to them (if they are still good companies) or sell them (if they are becoming bad companies). If you do wish to continue, though, you should know that value investing is the most tried and true approach to investing in the stock market.

Ben Graham averaged over 20% returns per year for two decades. Besides his two partners, there were four employees of Graham-Newman Investing. Three of those four later made incredible money investing on their own. Walter Schloss was one; he averaged a 16% annual return over 25 years, doubling the average yearly return of the S&P 500 of 8%. Tom Knapp was another; his investment firm doubled the average yearly return of the S&P over 15 years (16% per year). The third was Warren Buffett. Over the last 28 years, his Berkshire Hathaway has averaged over 20% annual returns.

So, if you choose to be an enterprising investor, know that in investing based only on value and price, you will do well. You may not always beat the stock market averages, but if you work hard and are willing to learn from your mistakes, you just might be the next great value investor.

Before you begin buying stocks, think about how much money you have to invest. If you do not have more than $10,000 to invest, then take that money and put it in a low-cost index fund (again, I like Vanguard). If you have less than $10,000, you will not be able to achieve adequate diversification, and the ups and downs of your portfolio will be harder for you to take.

Once you have your $10,000 in the mutual fund, keep it there. As you get more money, you can take that money and buy individual stocks. That way, if you do some really stupid things and lose a lot of money on your individual stocks, you will still have money sitting in your mutual fund. This will also help you sleep at night.

Now, as to buying individual stocks, the key is diversification. There are three kinds of diversification. First, diversify in time. If you buy all your stocks at one time, events that harm the market in general could cause your investments harm. Since you know value investing works in the long run, buying stocks for the rest of your life will give you this diversification. The next kind of diversification is industry diversification. If you were in tech stocks in 2000 you know what I mean. Also, certain industries can do badly for long periods (like the airline industry).

The last kind of diversification is diversification as to country. It is hard to buy many foreign stocks, so I recommend putting some money in an international index fund or two (Vanguard has those as well).

Disclosure: I invest in Vanguard ETFs. I have no connection to the company. My disclosure policy wears a wombat on its head to keep warm.

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