Don’t Buy Stocks, Part 1

Did the title get your attention?  You’re probably wondering, am I changing  my approach and now making a stock market prediction?  Have I turned bearish (pessimistic) as so many people are?  No.  Plain and simple.

What I want to do is save you from the potential losses caused by buying individual stocks.  Sadly, this is not merely an academic discussion, since I have known many people who have been crushed by losses in individual stocks.  It upsets me to know that the devastation could have been avoided.

Buying individual stocks certainly gives you something to talk about over drinks with your friends.  But I don’t believe that the cocktail chatter advantage means you should actually buy individual stocks.  I don’t invest in individual stocks for myself, and I don’t recommend it for my clients.

People always have their reasons as to why their favorite stock is just “great.”  Some have done their research and have created a model that predicts that the stock that they are going to buy will double in the next four years.  Others have been following the same company for decades and are convinced that now is the time to buy.

Usually they’re talking about well known companies, such as General Electric, Johnson & Johnson or General Motors.  Did I get you?  I made that last one up.  In actuality, no one has ever told me that he was planning to buy General Motors.  That’s good, because looking back, we now know that GM, even though it was once considered a solid “blue chip” stock, was not in fact such a smart investment .

And there’s the rub. Looking back, it is crystal clear that we should’ve bought Microsoft when it first went public.  We should’ve bought Google.  Anyone with the time and inclination can do the research and figure out which stocks they should’ve bought.  But it’s not so easy going forward.

For one thing, there’s an excellent chance that whatever you have learned that convinced you that a particular stock is a good buy is already known by everyone else.  Therefore, the current price already reflects the brilliant insights you so cherish.  But another reason is that stocks are inherently risky.  If you are not using mutual funds to achieve diversification, but only buying a few stocks, you’re adding to your risk, unnecessarily.

Chances are you’re buying the stock of a company that you know quite well. If you live in Seattle there’s a good chance that Microsoft and Starbucks are in your portfolio.  Great.  And if you live in Rochester, New York there’s an excellent chance that you had Eastman Kodak and Xerox in your portfolio. Not so great, we now know.

In Atlanta, many people have invested in Coca-Cola.  By the same token, people in Houston had invested in Enron.  Where you live, and what you are familiar with, are not good reasons for investing.

Neither is loyalty.  Maybe your grandfather gave you some stock before he died and told you never to sell it.  I’m sorry, and I mean no disrespect, but don’t listen.  That stock with a family pedigree could be the next General Motors.

Or maybe you used to work for a great company and you have accumulated a lot of stock in your former employer.  But were you lucky enough to have worked for Exxon or unlucky enough to have worked for Citigroup or Bear Stearns?  Why let luck play such an important factor in your investment success?

By now you get the idea.  I’ve probably been way too repetitive.  But this is a really important concept.

As Nick Murray, author of Simple Wealth, Inevitable Wealth, says “Diversification is the conscious decision never to be able to make a killing, in return for the priceless blessing of never getting killed.”

To be continued.