Is it worth the time and risk to have individual stocks in your portfolio, or should you instead invest in mutual funds or Structured Products, which give you exposure to sectors you like without the risk of placing all your eggs in one basket?
While there are many factors to consider here – like the amount of time you have to dedicate to investing – there is one other theory in investing that comes into play. Modern portfolio theory focuses on maximizing your return while minimizing your risk.
To summarize, modern portfolio theory says that there is a point where when you can combine different investments that will minimize risk for the entire portfolio while getting maximum returns. This occurs because when you combine assets, you are diversifying your unsystematic risk, or the risk related to one specific stock. You get this diversification because you buy stocks that have a low correlation to each other so that when one stock is up, the others are down.
With this risk diversification in mind, let’s look at the pros and cons you should consider when deciding on whether individual stocks are right for you.
- No management fees – When buying individual stocks, you see reduced fees. You don’t have to pay the fund company an annual management fee for investing your assets. Instead, you pay a fee when you buy the stock and one when you sell it. The rest of the time there are no additional costs. The longer you hold the stock, the lower your cost of ownership is. Since fees have a big impact on your return, this alone is a good reason to own individual stocks.
- High returns – Stocks have given the one of the highest historical returns among the various asset classes over the long-term. If you’re looking for a growth in your portfolio, investing in equities (stocks) are usually the way to go.
- Highly liquid – Most stocks trading on a major exchange can be easily bought and sold. This liquidity gives investors the flexibility to convert their stocks into cash if they suddenly need it in a hurry.
- Lack of adequate diversification – With individual stocks, it is harder to achieve diversification. Depending on what study you are looking at, you need to own between 20 and 100 stocks to achieve adequate diversification. This means that you will have more risk investing in individual stocks unless you own quite a few stocks.
- Not enough money to diversify – Achieving this diversification is harder the less money you have. Especially when you start investing, you are subjecting yourself to more risk due to the lack of diversity.
- Time consuming – When you own individual stocks, it requires more time from you to monitor your portfolio. You need to ensure that the companies you’ve invested in aren’t having business problems that could wipe out your bet. You also need to monitor industry and economic trends. You’re your own portfolio manager, so you must spend the time to ensure you’re not holding a bad position.
- It can be an emotional rollercoaster – With individual stocks, you need to learn how to keep your emotions in check. Stock prices can rise or fall sharply because of an overreaction to good or bad news and it becomes easier to sell a loser or buy a hot-tip stock because you can instantly log in and make the trade in minutes. This can increase your fees for trading and can also lock in losses that would have been avoidable by holding something a bit longer.
The Bottom Line
When you are trying to get as much return as you can for the least amount of risk, your number one concern should be diversification. A well-diversified portfolio will provide more benefits and less disadvantages than buying individual stocks alone. In fact, research shows that, over time, a well-diversified portfolio is the best way to gain the highest return at the lowest risk.
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