If you are toying with the idea of buying individual stocks it’s important to understand the pros and cons. The best way to master that knowledge is to compare individual stocks to the alternative – mutual funds. Let’s go through those differences now and then dive deeper into how to find the best stocks that fit your needs.
When you buy individual stocks, you pay commissions but they are usually very low – especially if you use a good online broker. You could easily trade thousands of shares for less than $10.
You could of course buy any number of mutual funds without paying any commission at all – but you’d have to pay ongoing management fees. Ongoing management fees can be very low (less than .15% per year) or very high (greater than 3% per year).
This depends on the mutual fund you buy. You must dig into the mutual fund prospectus in order to really know what it costs you to own the fund.
From a cost standpoint, stocks are generally much cheaper to own specifically because they don’t charge ongoing management fees. Your advisor might. But the stocks don’t.
Ease of Use
Both stocks and funds are pretty easy to use. Using an online broker you can buy or sell stocks or mutual funds in a snap. No big deal there.
What is important when you think about the ease of use is the investment strategy you use to guide your investments.
Remember I told you that mutual funds charge ongoing management fees while stocks don’t? Well the reason for this is that the mutual fund manager does all the research for you. It’s true that you must come up with a good strategy to buy and sell your funds but that’s far easier than to develop a stock picking strategy.
And when it comes to individual stocks, you must do the research yourself. You can’t just buy a stock and hold on to it forever. In the vast majority of cases, stocks that are hot today will become dogs if you give them enough time.
That’s why you must do a great deal of research when you consider which stocks to buy and sell and you must stay current to make sure that the stocks you own today are still solid. This will require you to develop expertise in stock research and that in turn is going to require a big time commitment from you as well.
For most people mutual funds are a far more efficient way to invest. They require less research upfront and on an ongoing basis. If you love doing the research and developing skills and strategies, buying stocks could be your best option.
When you buy a mutual fund, you own hundreds or thousands of stocks. Most people who hold individual stocks are far more concentrated than that.
I’ve seen some people own up to 60 stocks. But most people own far fewer individual stocks than that. As a result of this concentration of capital, people who own individual stocks have to accept more volatility and risk.
If you own one fund that owns hundreds of stocks and one of those stocks goes belly up, you might see a ½% drop in your capital. You can survive that. But if you own 10 individual stocks and one goes kaput, you just lost 10% of your money. Ouch.
This is not to say that mutual funds or that diversification eliminates risk. As 2007 demonstrated, when the market is bad, almost all stocks fall. That impacts people who buy mutual funds as well as people who buy individual stocks.
So yes, market conditions tend to impact all stocks (and the mutual funds that own stocks) but there are also business risks that impact specific stocks very differently than funds. Because your money is so concentrated when you buy individual stocks, you can expect much greater volatility and risk compared to owning funds.
The Final Word On Stocks vs Funds
Most people are better off with mutual funds or ETFs as compared to individual stocks. They are cheaper and safer once you consider all the time you save by not having to do a great deal of research that individual stock investors must do.
Owning individual stocks opens up the potential for you to hit a home run of course while funds do not often provide such an opportunity. Of course, with stocks, every time you have the chance to hit it out of the park you also have the risk of striking out. Most people want base hits when it comes to investing and mutual funds provide that opportunity far better.
Investment Liquidity and Individual Stocks
Investment liquidity refers to how quickly you can sell a particular investment and receive cash for it in exchange. If it doesn’t take long to accomplish the trade, your investment is said to be very liquid. If it typically takes a very long time to convert an investment into cash, it is considered illiquid.
Most stocks are very liquid. When you want to sell a stock all you generally have to do is place a market order to sell your shares and within 3 days, your trade will “settle”. After settlement, you’ll receive your cash. Shares are especially liquid if they are heavily traded.
In other words, if millions of shares are traded every day it won’t be hard for you to sell your shares at the prevailing market price whenever you like.
This is not the case with “thinly traded” stocks. A thinly traded stock is one that isn’t traded very much. If very few orders come in to buy or sell this stock every day, you may find it very difficult to sell your shares when you want to at the price you want to receive.
As a result, thinly traded shares may not be as liquid as you think. And it gets worse. When very few shares are traded, there is usually a huge difference between the buy and sell price – known as the “spread”.
The larger the “spread”, the greater the slippage (difference between the market price of the stock and what you will ultimately get when you sell) and that means thinly traded stocks cost more to trade than heavily traded shares.
Illiquidity is directly responsible for these additional costs. Before buying a stock, check it’s liquidity with your broker.
Where To Get The Most Information About Your Stocks – Shareholder Letters
Shareholder letters are the secret weapon the smart stock holders rely on to make good investments. Shareholder letters give you the inside story about what’s really happening with the company you are thinking about investing in.
You can obtain this information very easily; just go to the company’s website and download the most recent financial statements. While you are reviewing the balance sheet, income statement etc, make sure to read the shareholder letter very carefully.
It contains an inside look into the kind of management your company really has. The shareholder letter references the data within the financial statements. If they fill the letter with nebulous hopes and dreams, they might be trying to misdirect you.
The shareholder letter should give you an indication about the strength and quality of earnings. (Is the company profitable from ongoing operations? Are sales and margins expanding? Or are they selling assets and laying people off to slash costs in order to boost the bottom line.
The former indicates that the company is healthy. The latter does not.)
The shareholder letter will also tell you how the company sees its future – what the opportunities and challenges are and how they’re going to approach each. The management should also spell out how they plan to maximize shareholder value in this letter.
You can and should read between the lines when you go through the shareholder letter. Does the letter honestly disclose the debt levels the company has? Do they have enough working capital? Do they disclose cash flow problems when you know they have them by reviewing the statements themselves?
Let’s say you notice in the financial statements that sales are down compared to last year. Does the letter talk about this, or is important information left to footnotes (that nobody reads)?
Is the company investing in its future despite a slow business cycle? Do they discuss it openly? Has the company followed through on previous plans, or do they seem to be twisting in the wind? Do you get a sense that these people know how to make a business successful?
Obviously, you need to read the shareholder letter for a number of years to get the real sense of these and other items.
Look for a company that is honest about its challenges. Also, make sure the firm’s management has the fortitude to forge and execute important strategies that result in success. You get a sense of all this by what you find in the shareholder letter and also by noting what the management chooses not to discuss in the letter.
Get a sense of how honest and transparent the management is by reading this letter carefully. Read it as if you are an IRS auditor, not a “true believer.”
This takes work. Just like it takes work to make money. By reviewing the financial statements and the shareholder letter, you’ll be showing respect for the work you put in to make the money in the first place and give yourself the best shot at holding on to it.
If you are not willing to do this work but still like the idea of owning stocks, consider hiring an advisor that uses a stock strategy that makes sense to you.
Price to Earnings Ratio or P/E
Another thing to review before investing in any particular stock is the price to earnings ratio or P/E. It is the per share price compared to the per share earnings.
Historically the S&P 500’s average P/E has been around 15.5. This isn’t a hard and fast rule but anything above that might be a little pricey while anything below that might be an opportunity. Currently the S&P 500’s average P/E is about 24.
P/E isn’t the end all be all of stock picking, but you can use it as a general rule of stocks to continue looking at or stocks to be very skeptical of. A great example of this are two tech companies: Apple and Facebook.
Apple’s P/E is currently close to 20. The company has a massive pile of cash and is trading at a “moderate” P/E (compared to the market). I’m not saying I would invest in Apple immediately, but I would continue my research.
Facebook is a different story. Facebook’s P/E is currently around 37. That means it’s about 2 times as expensive as Apple. Clearly Facebook is more speculative.
Does this mean one stock is better than the other? No.
Does it mean one stock will rise in value faster than the other? No again.
It’s part of the puzzle and just something important to know when considering buying stocks. It gives you an idea of how speculative the stock might be and/or what the expectations currently are.
If a stock had a PE of (let’s say) 10, it would mean that the market has low expectations because it’s half the PE of the market. If you have reason to believe the stock will do quite well, it might be a good time to buy shares. If on the other hand you buy shares of a company with a PE of 50, you might get clobbered if the company fails to live up to high expectations.
Initial Public Offerings – IPOs
An IPO is an Initial Public Offer. This is a mechanism by which a company sells a portion of itself directly to the public by offering shares. There is a group of brokerage firms who “underwrite” the offering and these people are key players. Underwriters do the legal work and due diligence – or are supposed to.
They basically prepare the paperwork in order for the stock exchange to put buyers and sellers together who are interested in the shares.
The underwriters are given the responsibility to get the shares sold. With a hot offering like Facebook or Google, that isn’t a problem. There will be a great deal more demand than there will be shares available.
The reason the underwriters love to be involved in IPOs of course is the commissions they make.
What happens is that the company and the underwriters determine a value for the shares – that’s the price they think the public will pay for each share. And for every share the underwriters sell, they receive a nice fat commission.
You can see that this creates a huge conflict of interest between the brokers who are part of the underwriting group and the brokers’ clients who rely on them to look out for their own interests. This isn’t talked about much now but it was a big issue in the early 2000’s.
Back then the SEC levied huge fines against the largest brokerage firms for touting IPOs to the investing public that were total “schlock”.
This is a very complicated topic and the details aren’t that important. What is important is that when shares are offered as an IPO, those shares are sold to people before they hit the market. They are allocated to the brokers’ clients who have expressed interest in buying them.
So if you want to buy shares in a hot IPO that everyone else wants, you’ll have to have an account with a broker who is participating in the IPO – this is rarely a discount broker.
And even if you do have an account with a participating broker, you’ll probably only get shares if you have a large account – if the IPO is super hot.
If you don’t get shares on the IPO what are the options?
It’s usually not the end of the world if you don’t get IPO shares. Remember, you can always buy shares on the open market after the initial public offering is allocated.
After that, the people who did get the shares will be only too happy to sell them – at much higher prices than they paid for them of course. That’s the big pop everyone wants. It would be nice if you snag that sweet pop too but over the long run, it’s not a game changer.
Even if you bought Facebook, Google, Microsoft, Apple, Amazon, (etc) on the secondary market after the IPO, you would have done very nicely over the following years.
Are all IPOs sure things?
Nope. Not by a long shot. Sure there are success stories – but there are more tales of woe.
Netscape communications came public in 1995 and ignited the tech boom. Now, nobody knows where they are. And that’s not the only example.
In 2011, there was $38.7 billion worth of IPOs that came to market. More than half those companies lost share value that year.
If you are on the hunt for investment income you might consider buying preferred shares. Many investors are drawn to these puppies because they provide more income than bonds and more stability than stocks.
A no-brainer….right? Not so fast.
First let’s consider how they work. Then we’ll look at how smart an investment they are.
Preferred shares (also called preferred stocks) are considered stocks but they are actually more like bonds.
You give a company your money. They pay you a fixed dividend (as long as they have the cash to do so). They give you preferential treatment (compared to common stock shareholders) with respect to dividends and repayment in case of liquidation or bankruptcy. You’ll probably get higher dividends than common shareholders, and you’ll get your dividends before the common shareholders.
Meaning, until you get your full dividend, the common shareholders won’t get zilch. That’s why they call these investments preferred shares, and it can be an important part of dividend investing.
How are preferred shares like bonds?
They pay preferred shareholders a set amount – just like bonds. But they pay each quarter rather than every six months like bonds do. The payment is called a dividend because it isn’t an obligation of the company.
If you own preferreds and the company doesn’t pay, you can’t sue them for breach of contract like a bond holder can. Bond interest payments are contractual obligations. If a company misses a bond payment, they are in default. If a company misses a preferred dividend payment, the company is not in default. (Read “How Do Bonds Work?”)
How are they like equities?
They are also like equities in that preferred shareholders aren’t promised anything from the company, as I mentioned. If the company has the money, it will pay the interest. If it doesn’t have the cash, it won’t make the preferred stock payment.
Some preferred shares are “cumulative” – that means the company has to pay the preferreds all the dividends they missed in the past (if any) before the common shareholders get anything. In almost all cases, preferred dividends are a fixed amount and the amount doesn’t change.
What’s the pecking order?
Bond holders have to get paid before preferred shareholders, and preferred shareholders have to get their dividends before any dividends are paid to the common stock shareholders. That is known as the priority, and that priority follows through in case of liquidation.
In such a case, bond holders would get paid, and then preferred shareholders. After these two groups of investors get their money, anything left goes to the common stock shareholders.
What are the pros and cons of owning preferred shares?
The answer depends on what you are looking for and what kind of preferred shares you buy. Some preferred shares are convertible into common stock. They are called convertible preferred shares.
That’s a nice feature because it’s a way for investors to get their cake and eat it too. If the common stock price doesn’t go up, they still collect their quarterly dividends at least. If the share price goes sky high, they can convert into common shares and take advantage of the growth. Sweet.
But keep in mind that in most cases, the common stock price has to go up significantly before these preferred shares convert. As a result, preferred shareholders don’t get all of the price appreciation that common shareholders do.
Preferred shares don’t have voting rights (neither do bonds). Only common shareholders vote.
Bonds have a due date. That means the company will have to repay the debt at some fixed time. Preferred shares don’t. That means the company never has to redeem the shares. That adds risk to the preferreds. The company never has to pay you back. In fact, they never have to give you anything. If you no longer want to hold the preferred shares you can sell them for the going price.
In summary, the preferred shareholder doesn’t benefit by future earnings. They also don’t enjoy benefits if the common shares rise in value. That usually won’t impact preferred shareholders. Also, bonds have more security as they have to get paid while the preferred shareholders don’t.
So why would anyone buy a preferred share? Because the dividends they pay are usually much higher than the bond interest payments. This is because the risk of owning these shares is higher. That is the main reason people buy preferred shares in the first place – for the dividend.
So if you are looking for investment income, preferred shares might be a good alternative. But as I’ve written about before, I believe there are far better ways to provide more investment income over the long-haul.
Stocks, funds and ETFs are some alternatives but you can also trade options. Most people are familiar with the term but exactly what are stock options?. This is important because stock options have become more common in recent years. They are often included in employee compensation packages. They are also a tool investors use to increase investment income.
An option is a type of derivative that creates the ability to buy or sell a security at a predetermined price.
Options are not securities themselves, but a play on the direction of the underlying security. The underlying security can be individual stocks, bonds, commodity futures contracts or even currencies. Let’s start with some definitions:
This is the right to buy a stock at a specific price. There are also long- and short-calls. In a long call, the buyer pays a premium for the right to purchase the stock, and can exercise his option to buy when the stock price exceeds the call price plus the premium paid for it.
In this way, the buyer can make money on a rising stock price without ever owning the stock. If it never reaches a level at which he can make a profit, he lets the call expire and loses only the premium he paid for it.
This is an option used if you believe that a security will rise. You would sell a (covered) call if you own the stock and don’t think it is going to rise in value much over a given time period. If you are right, you’ll hold on to your stock – and pocket the premium.
If you plan on using this strategy, you would make sure to find out if you can write calls against your shares before you decide which stock to buy.
In a short call the buyer believes the security price will fall. You will have to sell the stock to the buyer of the call at the buyer’s option. This is a risky position to be in for the person making the short call. If the stock does drop, the gain will be limited to the amount of the premium; if the stock rises, the loss can be unlimited.
This is the right to sell a security at a specific price. Just as with calls, there are also long- and short-puts. With a long put the buyer buys the right to sell the security at a fixed price with the anticipation that the security price will fall.
If he figures out when to sell those shares, he’ll make a profit if the security falls below the exercise price plus the premium. If it doesn’t fall to that level he can just allow the put to expire and will only lose the premium paid for it.
A short put works when the buyer believes the security price will rise. If the security does rise above the exercise price, the buyer will make a profit equal to the amount of the premium. If the security doesn’t rise by more than the amount of the premium, the trader can lose up to the amount of the stock price.
This is the agreed upon price or security target price at which the option holder has agreed to trade the underlying security.
Essentially, this is the fee charged by the writer of the option.
Exercising, as in exercising an option
Exercising an option is simply completing the buy or sell by the option expiration date.
Options are usually taken for a specific period of time, which means they have an expiration date. After this, the options become worthless.
Confused? Unless you trade options regularly, it’s difficult to wrap your arms around the concepts completely. Options are not nearly as simple as holding the underlying securities themselves. But you can get a better understanding by studying the tutorials at online stock brokerage companies.
Stock options and employees
Stock options have become a popular form of compensation, especially for managers. They can be quite lucrative—or not—depending on what happens with the price of the underlying securities.
For employee stock options, the underlying security is most typically the stock of the employing company, though it can also be stock in an acquiring company. Employers will offer them to employees as an incentive to stay with the company and to motivate them to work harder so that higher stock prices are achieved and everyone benefits.
The options will include the right to be a certain number of shares of stock at a specified price during a limited time frame. The employer also typically establishes a vesting period of several years that restricts the employee from exercising the options. The vesting period is usually several years, which is one of the major ways that options keep employees from leaving the company.
The stock is usually offered at a discount, and when the options are exercised, the employee can sell all of the stock and realize an immediate gain, hold the stock for (hopefully) greater future gains, or sell some and hold the rest.
There are tax considerations with employee stock options that vary according to how the options are established. If your employer offers stock options you’re well advised to consult with a CPA for the proper tax treatment.
The risks of stock options
The risks of having stock options can be greater than actually holding the underlying stock or other securities. As we saw with short puts and short calls, you can lose 100% of the stock price and even more.
These are NOT appropriate for conservative or even aggressive investors in my opinion. They might be a good fit if you have expertise, a lot of money you can afford to lose and classify yourself as a speculator.
The risk to employee stock options is generally lower since you don’t have to pay for the options up front. However, there can be a risk if you accepted less cash compensation in exchange for stock options. If the desired option prices aren’t reached, you could have given up substantial compensation in exchange for an investment scheme that never played out.
Bottom Line On Individual Stocks
There is absolutely nothing wrong with buying individual stocks – if you have a good solid investment strategy.
I can’t emphasis this enough; your process and your strategy is far more important than any individual stock or fund pick.
That’s because your process is repeated. If you have a solid process, you should have solid results over the long run. If you have a flawed process, or no process at all, the chances are high that it will crash your financial ship on the rocks of investing reality.