The Pitfalls of Investing in Individual Stocks for Beginners

Why Diversification is Key for New Investors

As the new year begins, many individuals, especially young people, are considering venturing into the world of investing. However, the allure of buying individual stocks in well-known companies can be tempting. The promise of high returns and success stories shared on the internet may make it seem like a lucrative strategy. But according to Christine Benz, director of personal finance and retirement planning at Morningstar, investing in individual stocks is not the ideal approach for beginners. Instead, she advises focusing on building a diversified portfolio using low-cost mutual funds and exchange-traded funds (ETFs). In this article, we explore the risks associated with individual stocks and the benefits of diversification for novice investors.

The risks are too great with individual stocks:

The Dangers of Relying on Individual Stocks

Financial experts like Christine Benz advocate for the construction of broadly diversified portfolios due to the inherent risks associated with individual stocks. While the stock market, as a whole, has shown a historical upward trajectory, the fate of any single stock can be unpredictable. Investing solely in a few well-known companies exposes investors to significant dangers if any of their chosen stocks plummet in value. This outcome is particularly likely for those new to investing, who may lack the necessary knowledge and research skills to make informed decisions.

Benz’s original statement from June 2020 is even more relevant today. During the bull market that followed the Covid-19-related downturn, enthusiastic investors bid up stocks that seemed promising for the future. However, the subsequent performance of some of these companies serves as a cautionary tale. For instance, Peloton, which traded at around $50 per share in 2020, now trades at under $7. Similarly, Zoom, which was on the rise with a share price of approximately $243, is now available for $68. These examples highlight the potential pitfalls of investing in individual stocks without the necessary due diligence.

Diversification is the key to mitigating risks:

Spreading Your Bets for Safer Returns

For beginners, diversification is crucial in reducing the likelihood of a single investment negatively impacting overall returns. Instead of relying on a few hand-picked stocks, Benz recommends spreading investments across a wide range of the market. By doing so, the potential decline in one investment will have a less significant effect on the overall portfolio.

Benz suggests that utilizing broad market index funds is an investment strategy backed by extensive data and expected positive outcomes. Index mutual funds or ETFs aim to replicate the performance of a specific market benchmark. For example, investing in an ETF that tracks the S&P 500 provides exposure to around 500 stocks. Additionally, these funds often come with low or no annual fees since they do not require the oversight of high-priced managers.

You can still use stocks as a learning tool:

Gaining Experience and Knowledge

While individual stocks may not be the ideal starting point for beginners, they can still serve as a valuable learning tool. Investing in a few select stocks can help individuals understand the dynamics of the stock market and gain experience in analyzing company performance. However, it is crucial to approach this as a learning experience rather than a primary investment strategy.

Conclusion:

Aspiring investors, especially those new to the world of investing, should exercise caution when considering individual stocks as their primary investment strategy. The risks associated with relying on a few hand-picked stocks are significant, and the lack of research and due diligence can lead to poor investment decisions. Instead, beginners are advised to focus on building a diversified portfolio using low-cost mutual funds and ETFs. By spreading investments across the market, the potential negative impact of a single investment is minimized, increasing the chances of stable and positive returns. While individual stocks can be used as a learning tool, it is essential to approach them with the intent of gaining experience rather than relying solely on their performance. As the new year begins, it is crucial for new investors to prioritize diversification and make informed decisions to set a solid foundation for their investment journey.