Investing in Individual Stocks (Why I Do It)

by FI Fighter on February 20, 2015

in Stock Investing Thoughts

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I’m buying individual stocks again… There are many reasons to do so, and I will outline my own in this article. Although it would be incredible to beat the market (even just occasionally!), that’s not the main objective for handcrafting my own “index fund”. Yes, I will occasionally invest in some potential high-flyers with the intent of scoring some astronomical returns, but that’s more akin to gambling, so you’ll definitely see me adding in many more defensive holdings to mitigate risks.

In reality, I know there’s no way that I can outperform Wall Street, the hedge funds, and all their supercomputers… especially not on a consistent year-to-year basis!

Luckily, I don’t have to overthink things… Investing can be made quite easy when you simply elect to follow the market. Over a 10 year period (with dividends reinvested), the market’s annualized return has been a robust 7.65%.

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S&P 500 Returns Over 10 Years http://www.moneychimp.com/features/market_cagr.htm

Index Funds Rule

When it comes down to it, I actually love index funds. Love them, love them, love them!! I just never really talk about them much because they are so mundane and effortless to deal with. I’ve been investing in a Roth IRA since 2006, and contributing to a 401k (usually to the max) since 2009.

In that time, my Roth IRA has essentially doubled in value, and the 401k is up significantly… Once you include the company matching, I’m convinced those returns easily blow away what I could typically find on my own.

And it gets even better! The expense ratio for these index funds can be as low as 0.05% (VTSAX). For a low fee, I get to not only track the entire US market, but essentially go on full auto-pilot with my investments. All I have to do is pick out a total market index fund and make regular contributions. After that, it really is “set it and forget it”.

If I was a new investor just starting now, my first order of business would be to invest in index funds. In the long-haul, that’s probably the absolute best decision you can make and the most fool-proof. Why try and be a superhero when your foundation isn’t set?

When it comes to stock investing, it pays (literally) to be “average”! If you can just follow the market’s lead, you’ll end up outperforming 80% of actively managed funds.

Individual Stock Strategy

So, if I love index funds so much, why even bother investing in individual stocks? Well, there are a few reasons…

First off, I should emphasize again the importance of having a strong foundation in place. In my case, I have over $200,000 invested in index funds in my retirement accounts (Roth IRA and 401k) so I’m definitely not avoiding them. I also have an ownership stake in 8 properties (5 of my own rentals and 3 partnership deals), so investing in individual stocks is just another means of diversifying my investments.

Here’s my rational:

Total Control: Holdings and Asset Allocation

I think a good reason why so many investors elect to purchase individual stocks is because they are total control freaks who want to be the CEO, CFO, Board of Directors, and everything in between. 😉

When you self-manage and direct your own portfolio, there’s no one else to blame but yourself when things go wrong because you are taking on the burden and responsibility to do all the work. If that fits your personality and style, then investing in individual stocks may be perfect for you.

By electing to build your own portfolio, you get to choose not only the individual stock holdings, but also designate the asset allocation associated to each stock/industry.

You can mix and match to your heart’s content. In my case, I’m not trying to build a pure dividend growth portfolio comprised of only large cap blue chips. Yes, I plan on buying some classics like Coca-Cola (KO), Pepsi (PEP), Johnson and Johnson (JNJ), Chevron (CVX), etc., but since it’s my own portfolio, I get to do what I want to help me try and reach my goals. For my own portfolio, I want some strong dividend anchors (like the companies mentioned above), but in addition, I also want a blend of some growth plays as well. As such, I’m also making efforts to buy growth stocks such as Gilead Sciences (GILD) and Alibaba (BABA).

When it comes to best ideas, I only have so many… I want to stick to around 10-20 holdings, if I can. When you purchase index funds, most likely you’ll be buying a bunch of companies (100+ or even 1,000+). Some holdings you’ll like, while others you might not have even ever heard of! With your own portfolio, only the stocks you want to own will ever get purchased. 🙂

Further, I get to control the weighing of each stock position. Right now, BABA makes up over 40% of my portfolio, whereas Caterpillar (CAT) is only at 2.0%. That was by design, as I don’t ever plan on distributing equal weight for each stock position I own; I plan on allocating more heavily to what I feel are my best ideas.

When in comes to allocation by industry, that’s also something I get to control. For instance, I work in the high-tech hardware field, and don’t have a particularly strong motivation to invest in any hardware companies. I avoid tobacco companies altogether (although my index funds do invest and I can’t really control that!), and I have limited interest in REITs.

Everyone has got there own preferences, and by crafting your own portfolio, you get to do what you want!

Total Control: Buying and Selling

I’ll admit, I really like control. When I see a market pullback, I’m not alway interested in swallowing up the entire index. There will be many instances when I just want to own that SINGLE stock that is getting crushed because of some bad news (earnings miss, product recall, etc.) and causing investors to sell off.

Most recently, American Express (AXP) has had a string of issues, and the stock proceeded to drop over 10% in the last few trading sessions… In the process, the broader market indexes have all been going up! So, in cases like this, investing in index funds wouldn’t allow for the opportunity to snatch up these individual “bargains”. With index funds, you’ll always be buying the sum of all the companies, which by sheer numbers will always dampen out any peaks and valleys.

Likewise, when I sense the need to unload a stock, I like having the flexibility of only needing to sell a portion of any single stock that I desire. I can pick and choose my spots whereas I would have to always liquidate a portion of every holding using an index fund.

Higher Yield

Again, the total returns from an index fund (with dividends reinvested) will most likely trump whatever portfolio I can put together on my own, over the long run.

But depending on where you are in your early FI plan, total returns may not be the most important metric that you’re looking at… For instance, if I knew that I wasn’t going to retire from work for another 10+ years, I wouldn’t put so much effort into investing in individual stocks. Sure, I might take a flyer here and there, but for the most part, I would concentrate on systematically purchasing more index funds.

On the other hand, if I knew that I wanted to check out of the rat race in the next 1-2 years, I would work on buffering up the passive income as much as possible!

One drawback with these broader index funds is that the dividend yield on them is pretty low. As an example, if you follow the S&P 500 (VFIAX), you’ll see that the annual yield is only about 2.0%. Yes, you could always buy an ETF, or actively managed high yield fund, but those will come at a cost in the form of higher expense ratios… It may or may not be worthwhile to go that route, depending on your own situation. For me, personally, I prefer to handcraft my own high yield fund comprised of large cap dividend growth companies.

If you are an investor with a long time horizon until retirement, or early FI, that 2.0% initial yield may not mean much… But if you are only a few years away from needing that passive income (like me), or need it immediately, then even a few percentage points can make a huge difference.

Let’s suppose you wanted to start early FI today and had a portfolio valued at $500,000. At 2.0% annual yield, this would translate to $10,000/year, or $833.33/month to cover your living expenses… That might possibly work for some people, but I’m guessing it would only allow for a pretty uncomfortable lifestyle for most, filled with lots of sacrifices and compromises.

If we can boost the yield to 4.0%, the income would double to $20,000/year, or $1,666.66/month. That’s a dramatic improvement! Being able to double your expenses would do wonders in improving your quality of living in retirement, wouldn’t you agree?

With investing, there are seldom free lunches! If you want high yield, be prepared to either take on more risk, or sacrifice appreciation. The highest quality dividend stocks (that balance risk and yield) are typically large cap stocks that are stable, but lack substantial growth prospects.

More Defensive

Elaborating on the idea of “risk”, there’s a reason dividend growth investors sacrifice a few percentage points on yield to own more stable companies.

When the markets are shining brightly, everyone investing looks like a genius. But when the music stops, and it always does, you’ll quickly learn that high yield is not the end all that it might first appear to be.

Back in 2012, I was a new investor attempting to build up a passive income portfolio. I bought up shares in Seadrill (SDRL) because it appeared to be not only a growth stock, but also one that paid out an enormous dividend yield (7%+). The first few months of ownership were great, and the stock just kept going up in value. Not only that, but I was collecting a massive quarterly dividend that only appeared to be getting fatter and fatter! The best of both worlds — appreciation and high yield! I was on a roll!

Well, those good times didn’t last long, and luckily I got out when I did… Since that time, SDRL has lost more than half its value, and the dividend has been cut entirely. This whole experience reaffirms the important point that often times “slow and steady” does really win the race.

With my own portfolio, I want my dividend holdings to be the best of the best. Again, this means buying quality large cap blue chips that can not only withstand the worst of economic recessions, but keep on increasing dividend payouts in the process.

When the market tanks, even the best index funds will collapse with it. Since most index funds have unpredictable dividend payouts, it won’t be exactly reassuring to see the stock price go down along with the passive income.

There’s something very psychologically reassuring about seeing a growing income stream, in spite of price erosion and chaos in the air; it calms the nerves and gives you the conviction to stay the course. And that’s why I want the ability to hand select which dividend stalwarts I introduce into the mix. Preferably, I’m buying up dividend aristocrats to anchor and protect my portfolio when things get really bad.

The more defensive dividend growth stocks will also have a lower beta than the market, which implies less volatility (peaks and valleys). Further, the best dividend growth stocks have a natural floor built-in, since dropping the share price results in a higher dividend yield. And when things hit the fan, everyone will be turning to whatever safe havens they can find… Dividend aristocrats will assuredly fit the bill.

Hyper-Growth

I’ll admit that I am a bit of a gambler. Yes, I know that I’m not smart enough to beat the market… especially not on a consistent basis… But that doesn’t mean I’m not going to occasionally try! 😉

Disclaimer: This is NOT a suitable strategy for every investor. Again, I would like to emphasize the importance of securing a robust and stable portfolio first before attempting to hit a home run. The odds are great that you will lose a lot of money attempting this!

We all have our best ideas… When you pour hours upon hours into researching individual stocks, eventually you’re bound to come across a company that you believe has what it takes to make you a lot of money… We’re talking hyper-growth stocks here… The ones where you back the truck up and swing for the fences.

Investing in individual stocks allow an investor the opportunity to load up on any potential hyper-growth stories. For instance, if you had ventured into an Apple store in the summer of 2007, you might have had an inkling that the “next big thing” would be a smartphone revolution. If you were convinced that the iPhone would some day rule the world, then investing in AAPL stock would have been the way to do it. Who needs an index fund if you have full conviction in your best idea? Had you done so, you would have annihilated the market and made returns beyond your wildest imagination. I once heard a story from a co-worker about a guy he knew who bought AAPL shares consistently throughout the subprime mortgage crisis and was sitting on over 7,000 shares, last I heard. That’s almost $1MM in value! One right move, and you are set for life!

I missed the boat with AAPL (doh!), but I got in on Tesla Motors (TSLA) before the earnings pop in Q2 2013. With that one, I read all the reports, did all the research, and was absolutely convinced that the stock would pop soon. So, I backed up the truck on that one… Although I now wish I would have loaded up on even more shares… oh, hindsight…

Today, I’m placing a bet on BABA and hoping that it will take off in the future due to the overwhelming growth potential of China’s middleclass… Will that come to fruition? That’s anyone’s guess, but I’m obviously optimistic about the potential this has for earnings and revenue growth. Again, because I am my own money manager, investing in individual stocks gives me the freedom to allocate my holdings in any way, shape, or form that I see fit. Probably not suitable for anyone else, but right now about 40% of my individual stock portfolio is tied up in BABA shares…

Again, this strategy is definitely not without risk! Anytime you gamble large, you risk striking out. In this example, if the market continues to hammer BABA and it doesn’t grow as expected, investors will be merciless… At that point, I’ll definitely wish that I had put the money into a more diversified index fund!

Higher risk, higher reward…

It’s Fun!

Lastly, I invest in individual stocks because it’s fun! My true mission is early financial independence, but I’ll confess that investing has sort of become a hobby of mine.

This kind of goes back to the whole control part, but there’s just something so exciting about being able to direct and handcraft your own stock portfolio… I sort of liken it to that of being a general manager of a professional sports team.

And when you get results, it’s empowering… probably more so than if you were to get identical results (or even slightly better ones) using an index fund. Yes, that defies logic, I’m not gonna argue that…

There’s a human element involved with building your own portfolio, definitely… that’s undeniable. Although they do say that in order to succeed as an investor you need to remove all emotional attachment…

I still remember how difficult it was when I had to liquidate my dividend portfolio back in 2013… That’s something I need to work on, but I do think things have gotten easier over time.

For better or worse…

 

Why do you invest in individual stocks?

{ 1 comment… read it below or add one }

1 Jason @ Islands of InvestingNo Gravatar February 20, 2015 at 12:28 pm

That’s a great case you’ve outlined FI Fighter for your own reasons for investing directly in stocks – a few of those resonate with me too, and I previously highlighted a few of my own reasons why I like investing directly in stocks:

http://www.islandsofinvesting.com/6-great-reasons-to-invest-directly-in-stocks/

Similar to your ‘control’ point, I’m a big fan of creating a portfolio that’s tailored to your own personal characteristics – and I agree with it being fun!

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