Stock Picking - Creating a Diversified Portfolio

Individual Stocks or Mutual Funds?

Owning individual stocks offers several benefits to investors—the first knowing exactly what you own.  Hopefully, you’ll know more about your stocks than just the stock symbol.  Peter Lynch, former manager of the Fidelity Magellan Fund, said you need to be able to explain in one minute why you own a stock.  Another benefit is that you decide when to buy and sell.  Controlling the timing of gains and losses are important with your income taxes.  You can’t get this control investing in mutual funds.  Sure, you can invest in tax efficient funds, but as a fund shareholder you can’t control when dividends and capital gains are distributed.  Some people accumulate certain stocks when they inherit shares, buy stock in the company they work for, or buy shares from the insurance company they have their policies with.

Beginner investors shouldn’t invest in individual stocks—they should use mutual funds.  The first mutual fund opened should be a short-term bond fund for your cash reserve fund.  After this is set up you can start investing.  Most people also invest in their 401(k) plan or other retirement plan offered at work.  This would also be done using mutual funds as this is the primary option for retirement plans.  After accumulating a certain amount of money, you can “graduate” and invest in individual stocks.  How much money is needed?  As a practical matter, it’s difficult to invest in individual stocks with less than a million dollars.  There are two main reasons for this—diversification and cost. 

How to Diversify your Portfolio

Diversifying your portfolio means spreading your investments across different industries and market capitalization.  Many studies indicate at least 25 stocks are needed to have a diversified portfolio.  Said differently, don’t invest more than 4% of your equity allocation into one position.  For example, assume you have one million dollars and you’re allocating 60% or $600,000 to equities.  With an equal amount invested into each stock, you would have about $24,000 in each position.

Managing the Costs of Trading Stocks

The cost of buying and selling stocks varies from paying full commissions down to on-line trading.  I suspect on-line commissions to buy and sell stocks are headed to zero, but remember…you always get what you pay for.  Even if you’re not trading on-line, commissions have been declining as the cost of trading stocks has become a commodity.  Like other commodities, this is reflected in the price and there’s no value added.  However, there are other costs to consider.  First, there’s the spread, which is the difference between the bid and the ask price.  For example, if you bought a stock that cost $20, you might get $19 ¾ when selling it.  The difference is the spread, which is the profit the dealers make.  Second, it’s not practical to own individual stocks for some asset classes.  For example, for most investors it’s not cost effective to own individual stocks for your foreign exposure.  To adequately diversify the foreign portion of your portfolio, you would need to buy a lot of different stocks.   The commissions to buy and sell all of these stocks would be very expensive.

A mutual fund or an ETF should be used for this asset class.  The biggest cost, however, is your time.  What is your time worth?  Well, if you earned $100,000 a year and worked 2,000 hours, it’s worth $50 an hour.  At $50 an hour, should you be spending your time researching stocks at night on your home computer?  It’s probably not the best use of your time.  And do you really want to be competing with professionals that do this for a living?  Most people that tried this in the late 1990’s had their hat handed to them.

Exceptions

Like many other rules, there are exceptions:

• Many employees think they should own their employers’ stock.  You believe in the company, are contributing to its success, and therefore, want to be a stockholder.  This is your third employer and you’ve bought stock in all of them.
• A family member gave you shares.
• You inherited stock.
• You joined an investment club and bought stock in a few companies from the ideas discussed at the meetings.
• You bought some stock for your children to teach them about investing.

So, as stated in the above examples, there can be a place for individual stocks in your portfolio—even without a million dollars.

Dont' Forget the 10% Rule When Buying Individual Stocks

When buying individual stocks remember the 10% rule—don’t invest more than 10% of your equity allocation into one stock.  This is far more liberal than the textbook definition of not having more than 4% of your equity allocation in any one stock.  Why can you invest up to 10% of your equity allocation into one stock?  It’s simple—the real world doesn’t always work the way textbooks say it should.

Today many people are entrepreneurs and own a closely-held or family business.  These businesses come in many different industries and sizes…from the corner grocery store to a large manufacturer.  When taking private investment into account, many small business owners have more than 10% of their equity exposure invested in these enterprises.  These business owners have created value, perhaps provided employment and, hopefully, put themselves on the road to financial independence.  Many small business owners continually reinvest in their businesses because of the rate of return that it provides.  They’re not about to stop growing their business just because it represents more than 10% of their equity allocation.  Private equity investment is how many people have accumulated a significant portion of their net-worth.  It’s the same with liquid investments like mutual funds and individual stocks.  Essentially, you can let your winners run…but only up to a point.  Make sure you remember this rule.  Many investors ignored it in the late 1990’s and got into big trouble.  A stock did well, so they just let it ride.  If the stock continues to rise, these shares could represent 25% or more of their equity investments.  The problem now becomes specific stock risk.  The risk of having so much money invested in one stock isn’t worth the potential reward.  Even some supposedly great companies have come back to earth.  For many years IBM or Big Blue, as it’s called, was a stock everyone had to own.  Then in the 1980’s, while the market was chugging along, IBM struggled.  During this time it wasn’t Big Blue, it was singing the blues.  The company eventually turned this around and has regained its Blue Chip status.  Some other examples of formerly great companies are Kodak, Sears Roebuck, and Woolworth.  The fact that great companies’ stock can fall has happened repeatedly throughout history and there’s no reason to believe this won’t continue to happen.

The Home Field Advantage  

If you do invest in individual stocks, remember to play on the “home field.”  Did you notice that some people who work in technology invest predominantly in gold mining stocks?  Or investors that spent an entire career in the pharmaceutical industry “specialize” in technology stocks.  What about those bank executives investing heavily in biotechnology?  Does this make sense?  It doesn’t to me, but it seems to happen frequently.  This isn’t playing on the home field.  If you work in the technology industry, why not invest a portion of your portfolio in technology stocks or mutual funds?  You’ve worked in an industry every day, perhaps for many years.  You know whom your employer’s competitors are, what differentiates them from others, and on some level, how they are doing.  Another way to play on the home field is to invest in local companies.  Investing in local companies makes it easier for you to get the pulse of the company.  Perhaps they’ll get local media exposure, making it easier to get more information about the company.  Maybe you can arrange to meet the head of investor relations and tour the local facility.  Additionally, the annual stockholders meeting might be held locally making it easier to attend.  For example, several years ago a local bank in our area went public.  Depositors could buy stock at the initial public offering (IPO) price of $10 a share.  Many depositors at the bank said, “No thanks.”  They weren’t going to invest in an IPO from a local bank.  They were sticking with the investments they already owned.  Three years later the bank was acquired for $52 a share.  Not a bad rate of return.  Was this investment a “no-brainer?”  With the benefit of hindsight—sure, but it really wasn’t.  Partially, the stars were aligned for the bank—given its location, management team, the interest rate environment, and consolidation in the industry.  Depositors had enough faith in their local bank to have their checking, savings, and perhaps IRA accounts invested.  But no, they didn’t want to buy the stock!  These “five baggers”, as Peter Lynch calls them, go up five times.  They don’t show up everyday, and when they do, it’s probably not where you have your checking account or even in your town.

Are all of the companies that go public in your area going to be five baggers?  Not likely.  But remember to play on the home field when investing in individual stocks.

A prospectus can be obtained from your investment professional.  The prospectus contains complete information on the fund’s investment objective(s), the risks associated with the investment in the fund, the fees, charges, and expenses involved, as well as other information about the fund.  You should consider this information and read the prospectus carefully before investing.

If you have any questions regarding your stock or mutual funds, please give Tom Scanlon a call at (860) 646-2465 or email TomS@Borgidacpas.com