Today after work I met up with a couple of friends for dinner, and the conversation eventually shifted to money. One of my buddies who is really good at fixing cars and basically everything engineering (the exact opposite of myself) said that he really wanted to open an account to pick a few stocks. Being a car guy, he really want to own a few shares of a certain car company, because he admired the cars they made and the company culture.
Of course, this is not a new conversation for me. I’ve had this discussion many times before, but I’ve never felt entirely successful at conveying how I feel about this idea. In a nutshell, I’m a little conflicted, because I think getting started investing in stocks early (my friend is a young guy) is important, but on the other hand, many people have been burnt in the markets by using individual stocks and therefore lost all interest in investing.
So instead of launching into my usual spiel, I told him I had one rule. The rule was he could not buy one stock before he read a book called The Little Book that Beats the Market.
The book is by Joel Greenblatt, a world-renowned investor and more importantly, a really good storyteller. It’s a short book, and very easy to read. Some of the hype put out by the publisher on the book jacket makes me a little uneasy, but there’s no quicker way that I know of to learn how to evaluate a stock than this book. And you can easily read it all cover to cover in under 3 hours.
I‘m not going to review the book here, but if you want more information or just want to go ahead and read it, you can get it on Amazon.
Now, the book claims that by knowing a few handy metrics and applying them consistently, you will outperform that market and look like a market genius. I’m afraid it makes it sound easier than it is, which you can see easily by realizing that if all it took were a few simple metrics, active mutual funds would always outperform the market, and index funds would be the laughing stock of the investment community. It is, unfortunately, not quite that simple. However, what reading the book will give you is a quick and dirty understanding of what analyzing a stock is all about.
But what’s even easier than reading that book (again, it’s a short read), is just taking my word for it and steering clear of buying individual stocks and buy stock mutual funds instead.
Why? Here are several practical reasons:
You Need to Be Diversified
Any stock can go bankrupt at any time. Seriously. Don’t believe me, go back and research the stories of Enron, Lehman Brothers, General Motors, or MF Global. These businesses and many others went bankrupt suddenly, with little or no warning ahead of time. In Enron’s case, it was an inside job of “cooking the books” which brought the company down, which no amount of stock analysis would have revealed.
Diversification is vital to your financial future, especially when you are young, because if your growing little nest egg gets cut down early, there’s less money to compound later on. Let’s say you’ve accumulated $10,000 by age 25, which is an impressive achievement. You invest it all in Enron, and this happens to be 2001. Overnight your $10k is gone. Had you simply diversified that money in an stock index fund, you would have about half a million dollars at age 65, assuming historical average stock market returns.
Trading Costs Matter
Studies going back to the 60s have differed on how many stocks you need to achieve diversification. One study from the late 60s claimed that just 15-16 stocks was sufficient to garner most of the benefits of diversification. Other more recent studies show that you need at least 50 stocks in a portfolio to be diversified. But for the sake of argument, let’s assume 15 stocks are enough, and that you want to do the stock-picking yourself. The good news about DIY investing is that you don’t have to pay a management fee, so that saves you anywhere from around 1% for an active stock fund to 0.06% for the cheapest stock index fund that I am aware of. But you still have transactions costs, and those can really add up.
Someone, a broker, has to execute your trades for you (unless you somehow have a seat on the stock exchange, in which case I highly doubt you’re reading my little blog). Now, the good news is that there are many discount online brokerage firms to choose from, and because of that they all try to compete with each other for your business. Most offer stock trades around $10/trade or cheaper, so let’s use that as our basic assumption. If you buy 15 stocks for your portfolio and change them out annually, that means you buy and sell 30 times each year (i.e. you sell the current position and buy a replacement). Doing the math on that comes to $300/year in trading costs, which means you need a portfolio size of at least $30,000 to keep your costs under 1%/year. Think 1% isn’t much? Over a 20 year period, 1% per year on a $1,000,000 portfolio is $220,000. That’s over $200,000 you’re in the whole just in trading costs alone. For most people, especially those who are just starting out, you should stick to a diversified stock mutual fund rather than trying to buy stocks on your own.
It Takes Hours of Research to Properly Research a Stock
Warren Buffett is famous for his seemingly tireless research of a stock before he buys it. He is said to have researched IBM for decades before finally pulling the trigger in 2011. Of course, this incessant research has helped him amass one of the world’s largest fortunes, simply by picking stocks and holding them for the long term. He gives this advice to other would-be investors:
Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.
His point is not that you can never change your mind about an investment. Instead, he is pointing out how important it is to really know a business before investing. You should get to know much more about the company than just the stock price and its recent performance. Who is the CEO? What is his growth strategy? What positive or negative market trends might propel or hinder it? What are the key financial ratios? How strong is the company’s competitive advantage?
In other words, never buy a company you aren’t ready to hold for the long-term, because that’s ultimately how you build wealth in the stock market.
Your Financial Focus Should be On Other Things
Last, like most people, your life is busy with concerns about work, family, and other more important things than stock analysis. I know it’s tempting to try your hand at picking stocks, thinking that maybe you are the next Warren Buffett, Peter Lynch, or Sir John Templeton. But remember, Buffett went to Columbia business school and studied under the legendary investor, Benjamin Graham. Also, Warren Buffett is, well, Warren Buffett.
You also might be tempted to think that it doesn’t really matter if you strike out with a small amount of money that you’ve saved up so far. It’s years until retirement and you’ve plenty of time on your side. That last part is actually all the more reason to not gamble with your nest egg. It might not be much now, but you haven’t yet sprinkled the magic dust of time on it. Today, ten thousand dollars may not seem like much. But if it grew at just the historic stock market return of 10%/year, ten grand would become nearly half a million dollars in forty years.
But it’s even more than that.
It’s more than that because while you’re focused on picking stocks, you’re not focused on a spending plan, paying off debt, and all kinds of other important decisions you are making on a daily basis. Humans can really only focus on a few things at one time, so trying to do everything perfect financially is just a recipe for burnout and frustration. However, just remember that while financial suicide can be committed by just one dumb mistake, financial heroism is achieved by a thousand smart choices.
At the end of the day, don’t be sidetracked by picking individual stocks. A simple stock mutual fund, such as an index fund, can provide you access to the stock market without the disadvantages of picking individual stocks. In my experience, those that keep it simple, spend less than they make, avoid unnecessary risks in investing, and are consistent in their daily financial decisions, are typically the most successful. I’ll never forget the one client that I had, who never made more than about $50,000/year, but ended up a multi-millionaire by the end of his life. He did by a daily frugality that was so practiced and comfortable, I think he had forgotten he was even doing it. In the end, he found success by investing simply, saving consistently, and staying the course for decades at a time.