Dumb Money: Investing in Individual Stocks

by Kevin on March 24, 2011

Every so often I write about something that I find incredibly dumb. I’ve added them to a Dumb Money series. You can go back through the archives and read about exactly how dumb things like smoking, withdrawing from retirement accounts early, and playing the lottery really are.

Today I’m going to share a story of my own incredible stupidity in regards to investing in individual stocks. Here’s to hoping you can learn from me and avoid making a similar mistake.

Young and a Pile of Cash

I graduated college a semester early in order to 1. be able to relocate to be near my then fiancée, 2. save my parents the cost of another semester of school. And yes, in that order. (Love before money… who’s heard that one before?)

As part of my graduation festivities my parents dumbfounded me by giving me a check. It was money they had been secretly saving up for me to help assist with an eventual down payment on a house. My graduating early had helped fund a portion of what they were giving me. We’re far from being an affluent family — smack dab in the middle class. For us it was a big check.

I was stunned.

They told me the money was mine to do with as I want, but they hoped I would one day use it as the foundation of purchasing a home. They knew I had discovered a real passion for personal finance in college and wasn’t likely to go blow it on a new car or something like that.

No, I wasn’t that dumb. I was potentially even more stupid because I wanted to grow this amazing gift into something better while not losing it.

Learning Investing

Instead of doing the intelligent thing and putting this money into a “boring investment” like a certificate of deposit or high-yield online savings account I decided I could handle investing it in the stock market on my own. Not in mutual funds, but in individual stocks. Investing in the stock market was sexy and surely I’d be alright?

This wasn’t exactly the same as blowing the money at the nearest casino, but it might as well have been. I was 21; young, dumb, and admitting I needed to learn about what I was doing. Learning is fine, but not when thousands of dollars that your parents saved for decades comes into play.

I signed up for a premium Morningstar.com account. Morningstar is a premium investing research website where legit analysts talk about their expectations, fair value, and growth opportunity for stocks and mutual funds. The account cost $135 per year at the time; they’re up to $185 per year today. As much as this might sound like a scam it isn’t. This is a legitimate research website that is quoted in Money magazine among many other “real” businesses and websites.

Why Individual Stocks are Terrible Investments

I used Morningstar’s methodology of identifying businesses with “moats” around them — hard to overcome barriers to entry in that industry. I’m a big fan of value investing (rather than growth investing) and used the analysts’ research to find companies that were both at a significant discount to their “fair value” stock price and enjoying a significant business moat. It’s a legitimate strategy that a mostly ignorant 21 year old had no business trying to succeed with.

Individual stocks are incredibly risky. Unless you own 30+ stocks you have very little diversification to protect you from market swings and company changes. A large chunk of your portfolio can disappear with one company. Imagine having your entire portfolio in 10 stocks and one of them goes under. There goes 10% of your nest egg!

Investing in individual stocks can be made less risky by doing an incredible amount of research on the firms you are interest in. But reading an analyst’s report on a company does not equate to an incredible amount of research. That’s where I made my mistake. At the end of the day the only people who can really afford to do all that research are professional investors, not someone who reads investing news for an hour per day then goes on with his life.

I Got Burned, But My Portfolio Survived

I need to go back through my tax records to find the lists of companies I invested in, but it wasn’t pretty. I had at least one firm go bankrupt due to the subprime lending mess. That was New Century Financial. At one point I was up 20% on the stock and should have sold, but held on all the way until the bitter end. I took something like a 90% loss on my investment in the company.

I didn’t dump all my money into a few stocks. I had at least 15 holdings, and that diversification helped me not lose everything. I had one or two stocks that did exceptionally well (40%+ gains over two years), and others that performed decently (5-12% growth over two years). Those helped offset the stocks that dropped 25%, 50%, or 90% like New Century Financial.

I remember sitting at my desk when I found out about what had happened with the subprime mess and how the whole company I had invested in was essentially gone. That was a hard lesson especially knowing if I had only cashed out when my holding was up…

My portfolio survived. Over a two year period I earned somewhere around a 3% annual return. This was when online certificates of deposit were in the 3-4% range, so technically I lost a bit of money in comparison to what I could have earned with that no-risk investment.

The tough lesson was learned: I had bitten off well more than I could chew. To this day I know I’m incredibly lucky that I didn’t lose a massive portion of that generous gift my parents gave me. You can bet I won’t make an investing mistake like that again… at least not with individual stocks.

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