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I don’t buy stocks in individual companies and I don’t think you should either. I’ll tell you why later but first a little Econ 101 (Don’t worry, I’ll be brief).

A stock is a small piece of ownership in a company. Companies sell shares to raise money. This money is typically used to help a company grow. Let’s say that you have a small furniture making business. You can produce about one nice piece a week. You realize that you could make more money if you hired additional workers, got some better equipment and maybe a little bigger shop. It turns out that you have a buddy named Joe that has a little extra cash just burning a hole in his pocket. He tells you that he will give you the money you need if he gets 50 percent ownership of the company AND half the profits. You agree and you and your new partner go into business together.

Several years pass and your venture is very successful. Joe is very happy with the situation, you are running the business and he gets half the money. He knows the business inside and out and comes to visit the shop about once a week to have coffee and check on things.

You and Joe decide that business is so good that you could probably make even more money with a large building and better equipment and more workers. So you and your partner go find a few more people to invest in your business. Now Joe owns a quarter of the business and gets a quarter of the profits but since you expanded, he’s still happy because he is making more than he was before.

The years pass and you expand several more times, issuing more shares to more investors. Joe’s portion of the ownership continues to decline but he’s still happy because he is making a lot of money. Besides Joe is still a good friend and he knows exactly what’s going on in the business as he has a direct line to the top, that is you still get together to discuss the business.

Again many years pass and you decide to sell your share of your very profitable company. Joe decides to hang onto his. At this point Joe has a very small ownership stake in the company.

A new management team is brought into run things. Joe no longer has a direct line to the top. Sometimes he has trouble getting the management team to return his phone calls. His ownership share is no longer what it used to be and he no longer has direct access to the president of the company. The furniture company has some financial problems and over the next several months things go from bad to worse. Then one day the company files for bankruptcy. It turns out the head of accounting was embezzling money to feed his gambling habit and the president was too inept to catch onto the scheme. Joe now has no stake in the company, as equity share holders are left holding the bag when a company files bankrupt.

While our story above is fictitious, I’m going to use it to illustrate some points about buying shares in a large company. Here is a list of the reasons I don’t buy individual stocks; Risk, Access (to people and information) and Cost (time and money). I will expand on each category below.

Risk

Risk is the big shark in the investment ocean. Of course without risk then there usually isn’t any reward. Funny how that works, isn’t it.

Historically, individuals held their money in very low risk assets. They probably had most of their money in the bank or savings and loan (S&L). Companies offered pensions so there was little incentive to invest for retirement. In the US many people’s homes were one of their largest assets. Bank deposits are government insured, pensions used to be carved in stone and home values pretty much increase over time so all in all we used to be very risk adverse.

In a time when agriculture was much more prevalent in this country a farmer considered his land as his retirement. If he lived long enough he would either sell it or pass it down to the next generation. My grandfather also bought some stock in AT&T, what used to be called Widow’s and Orphan stock, probably what’s considered a “Blue Chip” today.

However, in the last few decades there has been a major shift from bank savings to stock market investing. What are the reasons: an aging population causing a strain on the retirement system, better marketing by the financial services sector or better access to information via the intranet? I’m not sure but the major theme is a shift to equities with a corresponding increase in risk.

I’m constantly amazed by the way financial advisors downplay risk. As an investor one of your major goals is to decrease risk. Companies do this all the time. They buy insurance the put in place stringent screening processes for employment and credit granting. Companies seek to decrease risk and you should to. First you have to understand risk. I was constantly lecturing my buddies in the late nineties about the ability of a stock to become worthless. These were finance and economics majors but they were all caught up in the bubble. Every investment seemed to turn to gold. Until that is Washington Mutual went bankrupt.

Let’s pause here and talk about the first bankruptcy. This seems to be a phenomenon with first time stock buyers. I’ve seen it happen too often to be a coincidence. You get a hot stock tip from a friend/brother/cousin etc that’s too hot to miss. You throw your money in and a year later after a depressing crash the company goes bankrupt. All your money is gone. It’s happened and it will continue to happen, it’s a risk you take when you play the equity markets. That first bankruptcy bites and I’ve seen it take a few people out of the market for good. And that’s probably for the better.

When you can’t afford to lose your money, you shouldn’t put it at risk. If you need your money, throw it in a bond or a CD or even a savings account. At least it won’t be gone! An investment in a stock is risky and you can and sometimes will lose that money. It’s the price you pay to play the game. That’s why mutual funds are so much better for the typical individual investor. I only invest in mutual funds.

In our story Joe took several risks but the nature of his risk changed over time. At first he bet on you and your company and risk losing all his money if something happened to you or the building. However, he knew you, he knew your skills and he decided to invest in a friend. By the time you sold your share in the company Joe had a different type of risk. He now no longer understood the entire business. He also no longer knew all the employees. Many things outside his control could now cause him to lose his investment; in this case he lost out on access to information and people.

Access to Information and People

Peter Lynch once managed the gigantic Magellan Fund at Fidelity. He had a very good record returning about 29% during his tenure. However, according to his book Beating the Street, he also had access to almost any CEO or other high ranking corporate officer. Can you get a meeting with the CEO of Wells Fargo, how about the president of your local bank?

With access comes information. By the time a hot new tip or some performance information has trickled down to the pages of Kiplinger’s or Money the financial machinery on Wall Street has already processed it and bought or sold shares accordingly and most likely the new information will be reflected in the price of the shares when you go to buy or sell the stock. It’s called the efficient market hypothesis and it claims that the price of a stock already reflects any information known about it. So if a head of a large mutual fund knows that the company you work for is having a great quarter before you do, what hope do you have in beating the market?

You don’t have access to the CEO and the information you have is old by the time you get it. If the market is efficient then an index fund is one of your best bets. You can’t beat the market so you only hope is to match it as cheaply as possible.

Again as or story above demonstrates, when you own a small portion of a company you have very little leverage with management. You don’t have the access to people and information like the large investors do. Mutual fund managers are large investors. They have access that you do not. Like or not, life is not fair and money buys access.

Cost (Time and Money)

Finally who has the time to do the proper analysis of each company to pick the winners? Financial analysts on Wall Street, that’s who. That’s all they do all day. Can you do that? Besides if the information you get is already old and priced in to the market what difference does it make how much research you do as an individual investor?

I for one would rather spend my time more wisely. I think a better investment might be going to school, learning a skill or even playing with your kids. Life’s way too short to wade through financial reports hoping to pick up something everyone else might have missed.

Use your time wisely, you have a very limited amount.

What about cost? It will cost you money to make a trade. In fact that’s what brokers are hoping you do; they want you to trade as much as possible so that can get their commission. Trading frequently is exactly what you don’t want to do.

You could try one of the self service discount brokers online. However, they have become increasingly more expensive and can nickel and dime you with small fees. A solution like ShareBuilder may be a good a good alternative, especially if you are leveraging dollar cost averaging.

Wrap Up

So that’s why I don’t buy individual stocks. At this point you may wonder what I do. If you haven’t guessed by now, I’ll tell you. I invest with mutual funds instead. I don’t think the typical investor is going to beat the market. I would rather spend my time doing something, anything else really, and let the market take care of itself. If I’m not going to beat the market then I might as well try to match it. In this case fees and expenses will be your biggest enemies. Low cost funds, like those offered by Vanguard, are a pretty good way to invest in the overall market while keeping fees low.

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