Wednesday, June 20, 2007

Investing in Individual Stocks and Bonds

Back in the days when cars had fins and a household felt lucky to have one television, people invested mostly by buying individual stocks and bonds. The market swung up and down in the 1950's and 1960's, and then really dipped in the 1970's. After that, the benefits of diversification became much more apparent, and investors have gravitated toward mutual funds, and now their latest iteration, ETFs. But what about investing in individual stocks and bonds? Is it a workable way to invest? Is it a good idea? Here are a few thoughts.

1. It'll take a lot of research and analysis. You'll have to look into a number of potential investments before you find a good one. And you'll need a number of good ones to have a reasonably diversified portfolio. Don't invest based solely on someone's recommendation, especially if you got it in a social setting. Would you take financial advice from a financial planner who's had a couple of drinks? If not, why would you take financial advice from an acquaintance or neighbor who's had a couple of drinks? People will boast about their winners, but you won't hear much about their losers. So you'll get only half the story.

2. You'll have the problem of too much choice. There are thousands of mutual funds and ETFs to choose from. There are many, many more individual stocks and bonds. Knowing where to begin your research, and where to stop, will be a challenge. Sure, the Internet provides you a lot of information. But it provides everyone a lot of information. You'll have no informational advantage from using the Internet. You may be thinking that if you had been an early investor in Microsoft or Berkshire Hathaway, you'd be trading up to a bigger yacht today. But which of the many thousands of stocks available today is the next Microsoft or Berkshire Hathaway?

3. You need to keep a lot of records. In order to do your tax returns correctly, you'll have to have a detailed history of the stocks you own. Of course, you need a record of how much you paid for it--and it has to be a good record, like an account statement or a trade confirmation. Your personal notes or your entry in some computer software won't carry a lot of weight with the IRS. And that's just the beginning. You'll need to keep track of stock splits and stock swaps resulting from mergers or corporate recapitalizations. If you participate in a dividend reinvestment program, keeping track of the tax basis in your shares becomes more complex. And if you inherit stock, you need to know the "carry over" basis in the stock (i.e.., its value on the date of death of the person who bequeathed the stock to you). Get used to the idea of keeping some paper records for a very long time, because many computerized records often don't have much legal value as evidence. Further, as computer storage technology changes over time, the data on those floppy disks in the back of your desk will be inaccessible soon, if they aren't already.

4. You still have to diversify, but diversification is much harder with individual stocks and bonds. You need a fair amount of capital to have reasonable diversification, with stockholdings across a number of different industry groups, and in foreign as well as American companies. You'll also need to have some bonds, and the bond part of your portfolio should have a variety of maturities, ranging from at least two to ten years.

5. Unlike mutual fund investments, you'd have to pay commissions to purchase stocks, and also the "bid-ask spread." Stocks are quoted in two prices in the stock market: (a) the "ask" price, at which you buy; and (b) the "bid" price, at which you sell. The difference between these two prices, called the "bid-ask spread" is tantamount to an expense of investing. If you invest for the long term, buying and holding stocks for years or decades, these costs tend to amortize over a long time and become fairly minor. But if you trade stocks a lot, these costs can significantly reduce your returns.

6. You'll face the temptation to trade stocks and bonds on a short term basis, selling whenever you have a bit of a profit. This is a bad idea, because short term trading generally is less profitable than buying and holding. But your stock broker may encourage short term trading because it generates commission income for him or her.

7. At the same time, you have to monitor your portfolio and sell the investments that seem to be going downhill. The value of stocks can sometimes evaporate very quickly. Ask Enron shareholders about this.

8. If you see finance as a hobby or avocation, and are willing to put a lot of time into it, investing in individual stocks and bonds may be enjoyable and profitable. But if all this investing stuff is just work and more work for you, stick with mutual funds and ETFs.

Crime News: what some people will do to get their fruits and vegetables.

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