Author: John Gerard Lewis, Gerard Wealth
Covestor model: Stable High Yield
Disclosure: Owns bonds of AIG, C and BAC
It’s a seldom heard and even more seldom heeded maxim: In general, people should not buy individual stocks.
Of course, you’d never know it today as an abiding investing principle, what with the paucity of personal finance acumen - exacerbated by frenetic financial TV shows. There rarely appears a story about, say, the more level-headed notion of mutual fund investing, unless it’s to capitalize on the star power of an engagingly punctilious Jack Bogle, founder of the Vanguard Funds.
But even the master’s index-funds-only mantra recedes into a charming anachronism once his interview ends and the trading types reappear with their yelping about this or that particular stock.
Oh, I know. It’s good TV. It’s sexy, exciting, fast. But for the non-professional watching from home, it falsely teaches that speculating is tantamount to proper investing.
Now, some readers may reply, “Well I don’t speculate. I watch these shows to get ideas, and then I do my research.” That’s great for those individual investors who understand balance sheets, income statements, cash flow statements and their embedded metrics.
But those people are the exception to the rule, and you shouldn’t fool yourself if you truly aren’t in their number. And even if you’re convinced that you are, no non-professional is capable of having professional-level analytical proficiency in every industry.
Speculating with other than “mad money” is simply irresponsible, though the TV producers know that issuing such caution deadens the arousal factor – and that’s not good TV. But even a reasoned, judicious approach to buying individual stocks is ill-advised if it is not a disciplined, top-down strategy.
Proper personal investing begins with allocation of assets among stocks, fixed-income securities, real estate, commodities (commonly gold and/or silver) and cash. This allocation depends on a variety of personal factors, but especially within the allocation to stocks one rule should override all others: diversification.
Why? It’s because of an insidious investing peril called specific-stock risk. It lurks beneath every company you buy, and you never know when it will rise up to bite you. That’s why investors need to spread their risk by not investing too much in any single stock.
If you want to own an individual stock, as opposed to simply investing in good mutual funds (that, by the way, provide diversification and professional management), a good rule of thumb is to limit your investment to a maximum of 4 percent of your equity holdings.
That means, of course, that if your stock portfolio consists of individual stocks and no mutual funds or exchange-traded funds, then you should hold at least 25 stocks. That’s an unmanageable prospect for most people, because it simply would require too much time to research and then winnow the candidates to 25, all apart from the ensuing daily portfolio management that would be required.
That’s right, daily management. Business news happens every day, and it’s often unexpected news that can suddenly wreck your entire portfolio if it’s not constructed properly. Here are 10 such hazards that can devastate a stock (price declines cited are approximate over the past 10 years):
2. Industry-Specific Risk: The financial crisis that accompanied the aforementioned recession clobbered the share prices at some of the nation’s largest financial institutions, including AIG (AIG), Citigroup (C) and Bank of America (BAC).
3. Government Policy Risk: President Clinton used Fannie Mae (FNMA) and Freddie Mac (FMCC) to ensure that unqualified people were able to buy homes that they couldn’t afford. The shares of each have declined by more than 40% over the past decade.
4. Material Cost Risk: High fuel prices are one reason that American Airlines (AAMRQ) is bankrupt. And Alcoa’s (AA) stock has dropped by 11% partly because the price of aluminum has been so unpredictable.
5. Technological Risk: A decade ago, who would have thought that the august Eastman Kodak Company (EKDKQ), eclipsed by the digital age, would be bankrupt, foundering aimlessly, and down 30% in share value?
6. Competitive Risk: Sprint Nextel (S), which has long struggled for telecom market share, is the poster child for competitive risk. Down 17% over 10 years.
7. Legal Risk: Tenet Healthcare (THC) has had legal problems since 2007 and in April agreed to pay the government almost $43 million to settle alleged violations of the False Claims Act. 10-year decline: 18%.
8. Key Executive Risk: Until the Facebook (FB) IPO mania set in, the looming question in Silicon Valley was what will become of Apple (AAPL) now that Steve Jobs is gone? And sometimes CEOs die more suddenly, as Micron Technology’s Steve Appleton did when the plane he was piloting crashed in February.
9. Management Risk: Company managers can make big mistakes. Jamie Dimon and his crew at JPMorgan Chase (JPM), revered for deftly managing through the financial crisis, stunned Wall Street earlier this month by announcing a $2 billion blunder. Shareholders lost 15% of their money in the days following the news.
10. Management Corruption Risk: Tyco International’s (TYC) ex-CEO Dennis Kozlowski was convicted in 2005 for looting millions from the company. The shares were pummeled. Kozlowski was denied parole last month and could remain in prison for another 18 years.