Part 4: Investing in Individual Stocks
Many beginner investors eventually face an important question: should they invest directly in individual stocks, or simply buy into an investment fund?
The goal of investing in common stocks (or any other asset) is to earn the greatest return for the least amount of risk. But whether an investor should gain stock exposure by purchasing individual stocks or through other means is an important question. In this post, I’ll discuss when it is appropriate for individual investors to directly purchase common stocks.
Direct Stock Ownership vs. Investment Funds
There are two ways for individual investors to gain exposure to common stocks:
- Purchasing individual stocks directly
- Investing indirectly through an investment fund
When should an individual investor favor direct ownership of common stocks over investment funds? That depends on who you ask.
The Case for Index Funds
Most finance academics and many financial advisors suggest investing in a simple, low-cost index fund. An index fund is an investment fund that replicates the performance of a stock index, such as the S&P 500.
Advocates of the indexing approach have plenty of evidence on their side. Most professionally managed funds – investment funds where analysts and portfolio managers have discretion to select stocks – underperform the simple index. According to indexing advocates, this should give individual investors pause. If highly credentialed, highly skilled professionals cannot do better than an index, why should an individual investor expect their results to be any better?
Many indexing advocates believe that the underperformance of professional stock fund managers is evidence of efficient markets. An efficient market is one in stock prices fairly and accurately incorporate all available information. This occurs because the market is an aggregation of trading decisions by thousands of informed investors. By passively holding an index, an investor is “hiring” the talents of every investment professional that trades in public markets.
The claim of efficient markets is heavily debated in the investment world, and I do not seek to engage in that debate now. For anyone who accepts efficient markets, the logical conclusion is that investment analysis, fundamental or otherwise, is a waste of effort. In an efficient market, stocks prices reflect the optimum risk-reward tradeoff. In my experience, however, this conclusion goes too far and misses some important points.
There is nothing wrong with investing in simple index funds. In fact, I think indexing is a perfectly sensible and even desirable strategy for most individual investors. I should also note that not all indexing advocates fully ascribe to the efficient markets argument. There are plenty of other reasons to advocate for indexing.
But, let me offer a more nuanced discussion of the “active” vs. “passive” investing debate. This discussion centers around the following point:
Investing and investment management are very distinct activities.
Investing vs. Investment Management
I agree completely that most individual investors shouldn’t try to beat professional fund managers at the fund manager’s game. But that doesn’t mean that individual investors can’t beat them at a different game.
The “game” that the majority of fund managers play is what investor Seth Klarman called the “short-term, relative performance derby.”
Structural Disadvantages of Investment Funds
Most investment funds are structured as mutual funds. I’ll go into detail on mutual funds in a later post. For now, I’ll just highlight a few key features of mutual funds that make long-term out performance of a benchmark index highly difficult.
First, fund shareholders can purchase or redeem shares in the fund on a daily basis. These transactions are made with the fund itself. That means that money can flow into or out of a fund with little friction. That may sound like a good feature for fund investors.
The problem is that money tends to flow into or out of a fund based on a fund’s most recent short-term performance, relative to both the fund’s benchmark index (such as the S&P 500 or some other index) and the fund’s peer group. This is what Klarman meant by “short-term, relative performance derby.”
This fund flow behavior leads to the perverse outcome of money flowing into funds near market tops when stocks are most overvalued and money flowing out of funds near market bottoms when stocks are most undervalued.
In addition, when mutual fund investors put money into a fund, they expect that money to be put to work. Fund managers do not have the option of sitting on large piles of cash waiting for great investment opportunities.
A second feature of mutual funds is that they are heavily biased towards size. Fund management fees are calculated as a fixed percentage (usually about 1%) of the size of the fund. For a fund to break even (i.e., pay their operating expenses), it will need at least several hundred million dollars in assets. And because fund costs do not increase proportionally with fund size, funds become more profitable as they get larger. As mutual funds grow, the universe of stocks that they can invest in shrinks.
There are other structural disadvantages which investment funds face that we do not need to elaborate on here. The point is that individual investors do not have to, nor should they try to compete with professional fund managers.
Advantages of Individual Investors
Private investors have two key advantages over professional money managers. First, private investors have significantly less capital than professional investment managers. As noted above, the investment universe for most fund managers is highly constrained due to fund size. Even an individual investor with millions of dollars in capital will have access to a much larger pool of potential investments. Private investors can focus their analytical efforts on those stocks most neglected by investment professionals.
The second major advantage that private investors have over professionals is that private investors do not face “career risk.” Most professional fund managers are not the majority owners of the fund management firm, and even if they were, a shrinking fund size can quickly threaten the fund’s viability. To avoid such a fate, fund managers generally avoid concentrating capital in high conviction ideas. Being wrong in the short term is too high a cost for most fund managers. In the investment business, mediocrity is simply a safer business model. Private investors, on the other hand, can accept the tradeoff between short-term underperformance and above-average long-term capital growth.
The conclusion from the above discussion is that although investment success is never assured, non-professional investors can tilt the odds in their favor by focusing on the unique advantages they have over most market participants.
What It Takes to Succeed as an Active Investor
Before a beginner goes out and tries to be the next Warren Buffett, it is important to consider the skillset, commitment, and behavioral makeup required for successful long-term active investing.
The skills needed to become an expert investor are obtainable. (As a shameless plug, we provide this training at the Fundamental Investing Institute.) At a minimum, an investor needs to know how to read and interpret financial statements, how to calculate and value business cash flows, and how to understand the economics of a given industry. In short, an investor needs to understand fundamental analysis, a subject which we will discuss in the next post.
As for the time commitment, an investor must have the ability and the willingness to devote ten or more hours a week to doing stock research. There is no point in investors doing something they do not enjoy. As for me, except for spending time with my family, there is nothing that I enjoy more than reading the financial press, analyzing businesses, and studying financial history. Enjoying the process is especially important because true investors spend far more time conducting research than in executing trades.
The final consideration is whether the investor has the appropriate psychological traits to be a successful investor. There is something very peculiar about public markets. The very ease with which stocks can be bought and sold, which should be a benefit to the investing public, is highly abused by most retail investors. Retail investors tend to sell when prices decline and buy when prices rise. This is, of course, the exact opposite of what they should be doing, but emotions take over. Investors must be able to think and act independently of the market. As Warren Buffett has said many times, the key to investment success is “to be fearful when others are greedy and be greedy when others are fearful.” This is easier said than done, as we are all prone to acting out of emotion rather than reason. Some introspection is required before jumping into common stock investing.
The Three T’s of Stock Investing
In short, a beginner investor should ask themselves the “Three T’s”: Time, Temperament, and Training
- Time – Am I able or willing to devote the time necessary to conduct serious investment research?
- Temperament – Do I have the discipline to avoid emotional mistakes and think independently of the market?
- Training – Do I have the skills necessary to evaluate companies?
If the answer to questions (1) or (2) above is “no,” then there is nothing wrong with investing in low-cost index funds. Feel free to skip our next post and move on to the last post in this guide series, where I discuss investment funds, including index funds.
If, however the answers to questions (1) and (2) above are “yes,” then it is time to get to work. In the next post, we will discuss fundamental stock analysis and how to apply it.
Beginner’s Guide to Stock Investing Series
If you’re just joining this series, you may want to start with the earlier posts:
- Part 1: What Is a Stock?
- Part 2: What Is the Stock Market?
- Part 3: How to Buy and Sell Stocks
In Part 5 of this guide, we will explore how investors analyze individual companies using fundamental analysis.
Summary
The decision to invest directly in individual stocks or through investment funds depends on the investor’s goals, skills, and temperament. While index funds offer a simple and effective strategy for many investors, individual stock investing can provide opportunities for those willing to devote the necessary time and effort.
Professional fund managers face structural constraints that individual investors do not, including fund size limitations, investor flows, and career risk. These constraints can make consistent out performance difficult. Individual investors, by contrast, can focus on neglected opportunities and take a longer-term perspective.
However, successful stock investing requires preparation. Investors must develop the skills to analyze businesses, commit time to research, and maintain the psychological discipline required to avoid emotional mistakes.
Before attempting to build a portfolio of individual stocks, beginners should honestly evaluate whether they possess the time, temperament, and training needed to pursue active investing successfully.
Key Takeaways
- Investors can gain stock exposure either through direct stock ownership or investment funds.
- Index funds provide a simple, low-cost strategy and are appropriate for many investors.
- Many professional fund managers struggle to outperform market indexes due to structural constraints.
- Individual investors may possess advantages over professional managers, including flexibility and the absence of career risk.
- Successful stock investing requires time, discipline, and financial training.
- Before investing directly in stocks, beginners should evaluate the Three T’s: Time, Temperament, and Training.
